How Conversion Factors Affect the Treasury Futures Wildcard Option

Summary

The answer explains the wildcard option through the adjustment needed between a Treasury futures position and its associated cash-bond position after the futures settlement price is fixed. It defines the tail as the portion of the basis position associated with one minus the bond’s conversion factor. Depending on whether the conversion factor is above or below one, exercising the option requires buying or selling bonds to rebalance that position.

The explanation focuses on conversion factors below one, which it says are typical in the described market setting. Lower-coupon bonds tend to have lower conversion factors, all else equal; with a factor below one, exercising involves selling bonds after the futures close. A lower factor means a larger tail to sell, bringing the effective strike closer and requiring a smaller cash-market move to recover the gross basis lost on exercise. This is a qualitative explanation for the relationship, not a numerical valuation model, and it depends on the described position and settlement mechanics.

Key ideas

• The wildcard option exercise can require rebalancing the cash-bond side of a futures basis position.
• The tail is described as the portion of the basis position equal to one minus the conversion factor.
• When the conversion factor is below one, the explanation says exercise involves selling bonds after the futures close.
• Lower conversion factors imply a larger tail to sell and can make the option easier to exercise in the stated setup.

Tags

# US Treasury Futures Wildcard Option


# US Treasury Futures Wildcard Option












How does the conversion factor for bonds impact the valuation of the wildcard option?

In the WN contract, bonds with lower coupons/conversion factors, have higher wildcard options and I am wondering why this is.

## Answer by user68819 (score 2)

https://quant.stackexchange.com/a/80360

Excercising your wildcard option involves you buying or selling the "tail" of your basis position in the market (tail = (1-CF) bonds).

When the CF > 1 you are usually holding too many futures relative to your spot position (when the settlement price for the future is fixed at the pit close). Therefore, you must buy more bonds. And vice versa when the CF < 1.

CFs (Conversion Factors) are usually less than 1 at the moment (lower coupons tend to have lower CFs all else the same). Therefore, excercising your wildcard involves you selling spot post futures close. The lower the CF the more tail you have to sell, therefore, technically this brings the strike of the wildcard closer to you. More intuitively you need less of a move in the cash market to recoup the gross basis you are losing by excercising the option.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.