If the bank enters an arbitrage play involving the cheapest－to－deliver
Treasury bond, which of the followingSusan Baker is a new hire at Crinson Bank’s
Chicago office. She has joined the risk arbitrage desk where she will be
training to take advantage of price discrepancies in the U.S. T-note futures and
Her managing director, Gerald Bigelow, has asked her to calculate parameters
for potential arbitrage opportunities for the bank given current market
conditions. At the time he asked the question, the cheapest-to-deliver T-notes
were at par, with a coupon rate of 8.5 percent. When trading futures, the risk
arbitrage desk borrows at 12 percent and lends at 4 percent.
Looking at the calendar, Baker calculates that there are 184 days to the
first coupon payment and 181 days from the first coupon payment to the second.
Any interest accrued will be paid when the T-note is delivered against the
futures contract, but Bigelow asks Baker not to concern herself in the
calculations with the impact of reinvesting the coupons or with transaction
To get a feel for the market, Baker first prices a 6-month futures contract
that has 184 days to expiration in a “simplified scenario.” She decides to use
the same interest rate for borrowing and lending, taking the average of the
bank’s borrowing and lending rates. Calculating the futures price under these
simplified assumptions, Baker tells Bigelow that the futures contract should
trade at 99.7059. Bigelow explains that the futures price is below par even
though the spot price is at par because of the benefit to a short seller of
receiving the T-note coupon payments.
Having calculated the futures price in the “simplified scenario,” Baker
modifies it to reflect the bank’s current borrowing and lending rates, and
calculates the corresponding no-arbitrage bands. She tells Bigelow that the
lower band will be at 97.7468. Bigelow checks her calculations, confirming that
the higher band will be at 101.6294.
Once they know the no-arbitrage bands for current market conditions, Baker
and Bigelow check the screen. They see that the market price of the futures
contract for which they’ve been calculating no-arbitrage bands is 103. Together,
they execute Baker’s first arbitrage play.
If the bank enters an arbitrage play involving the cheapest-to-deliver
Treasury bond, which of the following statements is INCORRECT？
A)The short position decides which bond to deliver.
B)The arbitrage play is no longer risk-free if the bank has a long position
in the cheapest-to-deliver bond.
C)The long position has the advantage in the arbitrage play.
D)The cheapest-to-deliver bond may change during the life of the