Cheapest-to-deliver

The deliverable bond, or in a credit default swap the deliverable obligation, that costs least for the short or the protection buyer to hand over. Futures prices and CDS recoveries are set by it.

Where you will meet it

Cheapest-to-deliver appears in 4 learning outcomes on the CFA syllabus. A few of them:

• Explain credit default swaps (CDS), covering index CDS as well as single-name CDS, and the terms that specify a particular CDS contract
  CFA Level II · Fixed Income

  “Single-name CDS reference one entity; the contract names a reference obligation that sets the seniority covered, and the payoff is based on the cheapest-to-deliver obligation of that seniority.”

• Explain the pricing of fixed-income forwards and futures, and work out their no-arbitrage value and say what it means
  CFA Level II · Derivatives and Risk Management

  “The short picks the cheapest-to-deliver bond, which drives the price.”

• Show how interest rate futures, forwards and swaps can reshape the risk and return of a portfolio
  CFA Level III · Derivatives and Risk Management

  “Futures needed = (target BPV − portfolio BPV) ÷ futures BPV, where futures BPV is roughly the cheapest-to-deliver bond's BPV ÷ its conversion factor.”

• Explain what counts as a credit event for CDS and how CDS contracts are settled
  CFA Level II · Fixed Income

  “Recovery is usually set by an auction on the cheapest-to-deliver obligation.”

See also

Buying protection · Credit default swap

Practise it

• Today's practice question One question, with every wrong option explained.
• Free Level I diagnostic test Twelve questions that show which topics to start with.
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