Futures Contract Delivery Options

Many futures contracts have a delivery option, whereby the seller can choose among several different “grades” of the underlying commodity or instrument when fulfilling delivery requirements of a futures contract. Naturally, we expect the seller to deliver the cheapest among available options. In futures jargon, this is called the cheapest-to-deliver option. The cheapest-to-deliver option is an example of a broader feature of many futures contracts, known as a “quality” option. Of course, futures buyers know about the delivery option, and therefore the futures prices reflects the value of the cheapest-to-deliver instrument.
As a specific example of a cheapest-to-deliver option, the 10-year Treasury note contract allows delivery of any Treasury note with a maturity between 61?2 and 10 years. This complicates the bond portfolio hedging problem. For the portfolio manager trying to hedge a bond portfolio with U.S. Treasury note futures, the cheapest-to-deliver feature means that a note can be hedged only based on an assumption about which note will actually be delivered. Furthermore, through time the cheapest-to-deliver note may vary, and, consequently, the hedge will have to be monitored regularly to make sure that it correctly reflects the note issue that is most likely to be delivered. Fortunately, because this is a common problem many commercial advisory services provide this information to portfolio managers and other investors.