Case Study: CTD and Repo Arbitrage DB Bank is believed to have pocketed over EURI00 million (USD89.4 million) after reportedly squeezing repo traders in a massive interest-rate futures position. The bank was able to take advantage of illiquidity in the cheapest-to-deliver bond that would have been used to settle a long futures position it entered, in a move that drew sharp criticism from some City rivals. In the trade, the Bank entered a calendar spread in which it went long the Eurex-listed BOBL March '01 future on German medium-ferm government bonds and sold the June "01 contract to offset the long position, said traders familiar with the transaction. One trader estimated the Bank had bought 145,000 March "0I contracts and sold the same number of June "01 futures. At the same time the Bank built up a massive long pasition via the repo market in the cheapest-to-deliver bond to settle the March future, in this case a 10-year Bund maturing in October 2005. Since the size of the '05 Bund issue is a paltry EURI0.2 billion, players short the March future would have needed to round up 82% of the outstanding bonds to deliver against their futures obligations. "It is almost inconceivable that this many of the Bunds can be delivered," said a director-derivatives strategy in London. "Typically traders would be able to rustle up no more than 25% of a cheapest-to-deliver bond issue," he added. At the same time it was building the futures position, the Bank borrowed the cheapest-to-deliver bonds in size via the repo market. Several traders claim the Bank failed to return the bonds to repo players by the agreed term, forcing players short the March future to deliver more expensive bonds or else buy back the now more expensive future. The Bank was able to do this because penalties for failure to deliver in the repo market are less onerous than those governing failure fo deliver on a future for physical delivery. Under Eurex rules, traders that fail to deliver on a future must pay 40 basis points of the face value of the bond per day. After a week the exchange is entitled to buy any eligible bond on behalf of the party with the long futures position and send the bill to the player with the short futures position, according to traders. Conversely. the equivalent penalty for failure to deliver in the repo market is 1.33 bps per day (IFR, March 2001). Questions Section 1. What is a calendar spread? Show DB's position using cash flow diagrams. 2. Put this together with DB's position in the repo market. 3. What is DB's position aiming for? 4. Could taking a carefully chosen position in the relevant maturity FRA, offset the losses that shorts have suffered? Explain carefully. 5. Explain how cheapest-to-deliver (CTD) bonds are determined. For needed information go to Web sites of futures exchanges