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Answer: A downward-sloping yield curve makes it more likely that short-maturity bonds will be cheapest-to-deliver.
**Correct Answer: D** **Explanation:** D is correct because a downward-sloping yield curve (where short-term rates are higher than long-term rates) tends to favor short-maturity bonds as these are more likely to be the cheapest to deliver. **Why the other options are incorrect:** - **A is incorrect**: An increase in yields tends to favor long-maturity low coupon bonds as the cheapest to deliver, not short maturity bonds. - **B is incorrect**: There are two embedded options associated with the delivery of a futures contract - the ability to use the cheapest to deliver bond and the "wild card play" where a short counterparty can choose when to deliver the bond. Both of these options benefit the short counterparty and therefore lower the futures price, not increase it. - **C is incorrect**: The short counterparty has the right to determine when during the month they will deliver the bond as part of the wild card play. They can also send a notification to deliver after the 2pm closing time so can exploit a time difference between the settlement of the futures at 2pm and the closing of the bond market later to try and buy the bond cheaper and deliver at the futures price. This benefits the short position, not the long position.
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A derivatives desk trades a large volume of US Treasury bond futures contracts. A junior analyst at the desk is asked to monitor the bond markets and the process of delivering a bond against an expiring futures contract. The analyst studies how changes in market conditions determine which bonds are more likely to be the cheapest-to-deliver and how the process of delivery impacts the futures price. Which of the following observations will the analyst find to be correct?
A
As bond yields increase, short maturity bonds with low coupons will tend to be the cheapest-to-deliver.
B
The embedded options associated with delivery against a US Treasury futures contract tend to increase the value of the contract.
C
The "wild card play" benefits owners of long positions in expiring futures contracts by allowing them to determine when counterparties holding short positions will deliver.
D
A downward-sloping yield curve makes it more likely that short-maturity bonds will be cheapest-to-deliver.
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