Conversion Factors and Hedge Tails in Treasury Futures Delivery
Summary
This note explains why conversion factors affect hedge ratios during the trading life of a deliverable Treasury futures contract but do not change the physical delivery quantity. Because the futures price does not move one-for-one with a particular bond, the conversion factor helps determine how much futures exposure offsets a bond position as yields change.
At delivery, the long futures holder receives the contract’s specified notional amount of bonds for each matching futures notional. That one-to-one settlement convention can leave a residual futures position if the trader maintained a conversion-factor-adjusted hedge. The note says traders should close the remaining futures exposure at the delivery settlement price to avoid ongoing market risk. It offers a concise explanation of the mechanism, but does not derive the exchange’s contract design or quantify hedge performance.
Key ideas
- Conversion factors adjust the futures hedge ratio because bond and futures prices respond differently to yield changes.
- Physical delivery uses a one-to-one notional exchange between futures and bonds.
- A conversion-factor-based hedge can leave residual futures exposure at delivery.
- Traders can close the residual futures position at the delivery settlement price to remove that exposure.
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Full text
# WN 30Yr UST Futures Conversion Factor vs Delivery Ratio # WN 30Yr UST Futures Conversion Factor vs Delivery Ratio What is the logic behind using the conversion factor in determining the hedge ratio of deliverable bonds in 30Yr UST futures (WN contracts) throughout the trading life of the contract, but then having a 1:1 ratio in actual delivery of the bond to the long futures holder in physical delivery period and therefore leaving a tail? Edit to clarify my question: If the deliverable bonds are specified at the onset of the contract, and a conversion factor is determined to make the deliverable bonds an equivalent yield, why does the conversion factor not follow into the delivery period? It would seem that if the notional amount of bonds to be delivered should be the inverse of the conversion factor for the bonds that are delivered; thus eliminating the requirement to trade the hedge tail at delivery. Why did the exchange specify the 1:1 ratio for delivery, rather the inverse of the conversion factor into the contract? ## Answer by Attack68 (score 2) https://quant.stackexchange.com/a/78203 Due to the existence of the conversion factor the futures price does not move 1:1 with the bond, so a position in a notional 1mm bonds and a notional 1mm futures will gain or lose PnL as market yields move around. Thus, in the trading phase the trader needs to hold the correct amount of futures in order that market yield movements does not gain or lose PnL. The conversion factor determines the weighting. When it comes to settlement the futures holder will accept delivery of the bonds and his short position will net out, he will only receive 1mm bonds for every 1mm notional futures position. Thus, as the contract goes to settlement the trader needs to close any residual futures positions at the exchange delivery settlement price to remain completely hedged. Failure to do this results in the trader having a residual futures position after settlement which will gain or lose PnL as the market continues to evolve.
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