Question

Formulas are given at the bottom of the exam. Show all of your calculations. Show the equation(s) you used. Show the values you substituted in. Show your calculations. (1) How is the conversion factor determined in the bond futures market? (Give a description.) How is it then used to determine by the short side which bond to deliver? What is the purpose of the conversion factor? (2) Consider a portfolio that consists of a 3-year zero-coupon bond with a face value of $5,000 and a 7-year zero-coupon bond with a face value of $5,000. The current yield on both bonds is 1 % per annum. What is the duration of the portfolio?

Answer 1

1)

• The conversion factor is the security's perfect value, utilizing what's to come agreement's conveyance date as worth date and the future's ostensible coupon rate as the security's yield. Hence the conversion factor of the bond futures is determined accordingly

Process of the determination of the conversion factor by the short side which bond to deliver is as follows:

• At some random time, the least expensive to-convey issue will be the one with the most minimal changed over cost, where the changed over cost is the bond's value partitioned by its CBOT conversion factor. Subsequently, when financing costs are beneath 8%, a brief span issue will be the least expensive to convey; its cost will have risen least.
• Purpose or Utilization of the conversion factor

The conversion factor is a key component in support figurings and, all the more for the most part, in the examination of all market activities including securities and prospects.

At the point when a fates agreement is held until development, the conveyance cost of a bond for physical settlement of things to come is gotten by increasing the bond's cost with its change factor.

2) Duration of the portfolio is 7 years since one of the bonds in the portfolio is 7 year zero coupon bond which will yield 1% per annum and with a face value of $5000.