Cheapest to Deliver
Cheapest to deliver is a method that is used to estimate which is the least expensive future contract for a seller to deliver to its buyer. The conversion factor is used to estimate the cheapest value. This conversion factor is generated by the Chicago Board of Trade (CBOT) and Chicago Mercantile Exchange (CME). Investors trading in futures contracts must be aware of the term cheapest to deliver and must gain a full understanding of this method.
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What is Cheapest to Deliver?
- It is the futures contract that consists of two parties a buyer and a seller. In the futures, the trader entered in a long position i.e. the buyer needs to fulfill his responsibilities of buying specific quantities of the underlying security, and the person holding a short position i.e. the seller must deliver those securities to the buyer at the cheapest value as per the date agreed by both the parties.
- What is short selling? In the future market if the trader believes that in the future the price of the underlying asset will decline then he can enter into a short position in the futures contract and buy that asset when the price falls i.e. at a lower value. The short seller earns profit from the difference between the price at which the asset is sold less the price at which the asset is bought.
- Cheapest to Deliver only takes place in contracts that allow delivery of a variety of different securities. For example, the Treasury Bond Future Contract specifies a condition where the investor can receive any treasury bond if it is within a maturity span and has a specific coupon rate.
- In simple words, Cheapest to deliver is the most cost-effective security that can be delivered to an investor with a long position by an investor holding a short position and fulfill their obligation.
How is Cheapest to Deliver Determined?
- It is quite challenging and important to determine the cheapest to deliver security for the person in a short position due to the imbalance between the market price and the conversion factor of the security. The conversion factor is determined by the Chicago Board of Trade (CBOT) and is used in the calculation for estimating the cheapest to deliver rate.
- The Conversion factors are calculated daily to adjust the differing value of that security meaning the market price of the security should be close to the deliverable market value of that security.
- The cost of acquiring the security for delivery in a futures contract is determined by the quoted price of the security plus any accrued interest to get the full amount. Whereas the cost that the long position will pay to the short position is determined by the product of the settlement price and the conversion factor plus any accrued interest.
- The Blue box determines what the short position must pay for acquiring the security and the Red box determines the price that long will pay to short for acquiring the security and short will receive for delivering that security to the long position.
- In the following scenario, the short position will try to maximize his profit by the difference between the proceeds that he receives by delivering the security and the price he paid for acquiring that security.
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Example:
- A holds a short position in the futures market. He has three bonds with different quoted prices and conversion factors that are eligible for delivery. The settlement price of the bond is $95. Calculate the Cheapest Delivery cost
Formulas:
- Cost of Acquiring (Short): Quoted Price of Security + Accrued Interest
- Cost of Acquiring (Long): Settlement Price*Conversion Factor + Accrued Interest
- Cheapest to Deliver Rate: Quoted Price of Security – (Settlement price*Conversion Factor)
The settlement price of the bond – $95
The Cheapest to Deliver bond is bond no.1 i.e. $4.92 because it gives the smallest difference between the cost of acquiring and the proceeds received from delivering that bond.
Bottom Line:
The cheapest to deliver method provides an opportunity to the trader with a short position to maximize his profit on the bond and the long position gets an advantage to enter into the futures contract at the lowest rate.
Author – Divyashri Kadam
About The Author – Divyashri is a Bachelor’s Degree Holder in Accounting and Finance. Also, a Certified Financial Modeling and Valuation Analyst (FMVA). She is enthusiastic to learn more about financial markets, financial analysis, and anything relating to stocks.
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