Delivery Standardisation: When a particular bond is delivered, a parameter known as its "Conversion Factor" (to be explained later) defines the price received by the party with the short position (the seller). Thus the cash received for each PKR 100 face value of the delivered bond is amended to include the conversion factor thus: (Quoted Futures price x Conversion factor) + Accrued interest. In the foregoing example, assume the conversion factor is 1.38. Then the cash price would be:This practice allows a Futures Exchange to produce comprehensive tables of Conversion factors. If, after rounding, the bond lasts for an exact number of six-month periods, the first coupon is assumed to be paid after six months. If, after rounding, the bond does not last for an exact number of six-month periods (ie there is an extra three months), the first coupon is assumed to be paid after three months and accrued interest is subtracted.
Calculating Conversion Factors: Consider a 10% coupon bond with 10 years and two months to maturity. For the purposes of calculating the conversion factor, assume the bond has exactly 10 years to maturity. The first coupon payment is assumed to be made after six months. With the hypothetical discount rate approved by SECP being 6%, the value of such a bond is:
As another, slightly more complicated, example of the rules of standardisation, consider an 8% coupon bond with 8 years and four months to maturity. For purposes of calculating the conversion factor, the bond is assumed to have exactly 8 years and three months to maturity. Hence, discounting all the payments back to a point in time three months from today at 6% per annum (compounded semi-annually) gives a value of:
Cheapest to deliver Bond: In the bond futures market, the party that has a short bond position may deliver any one of several bonds during the delivery month on a date of its choosing. Obviously, it will choose the "cheapest to deliver" bond. Because the party with the short position receives cash equal to:
(Quoted futures price x Conversion factor) + Accrued interest... (1)
And its cost of purchasing a bond is Quoted Spot Price + accrued interest... (2) Therefore, the cheapest to deliver bond is one for which (2) - (1) is minimum, or (Quoted futures price x Conversion factor) - Quoted Spot price is minimum.
Once the party with the short position has decided to deliver it can determine the cheapest-to-deliver bond by examining each of the bonds available in turn. As an example, let's assume that the current futures price is quoted as 93.25, and the following three bonds are being considered.
The relevant calculations to determine the cheapest to deliver bond are then:

======================================================
Bond 1.      99.50 - (93.25 x 1.0382)       = PKR 2.69
Bond 2      143.50 - (93.25 x 1.5188)       = PKR 1.87
Bond 3      119.75 - (93.25 x 1.2615)       = PKR 2.12
======================================================

Clearly, Bond 2 is the cheapest to deliver and will be chosen by the short party. A number of factors determine the cheapest-to-deliver bond. When bond yields are in excess of 6% (or whatever benchmark rate is chosen by regulators), the conversion factor system tends to favour delivery of low-coupon, long-maturity bonds.
When yields are less than 6%, the system tends to favour delivery of high-coupon, short-maturity bonds. Also, when the yield curve is upward sloping, there is tendency for bonds with a long time to maturity to be favoured, whereas when it is downward sloping, bonds with a short time to maturity will be delivered.
Determining the Quoted Futures Price: In all of the foregoing, we have still not discussed how the bond's Futures price is determined. Theoretically, a bond's Futures price is related to its Spot price by the relationship:

===============================================
Bond    Quoted Price (PKR)    Conversion Factor
-----------------------------------------------
1.             99.50                     1.0382
2.            143.50                     1.5188
3.            119.75                     1.2615
===============================================
=======================================================
Coupon   Current    Coupon    Maturity  of       Coupon
Payment    time    Payment   futures Contract   payment
-------------------------------------------------------
     60              122            148              35
    days            days           days            days
=======================================================

According to the diagram, the last coupon payment date was 60 days ago, and the next coupon payment date is in 122 days. Thereafter, the next coupon payment date is 305 days from today (122+148+35). Let's also assume that the term structure of interest rate is flat, and the rate of interest (with continuous compounding) is 10% per annum.
The cash price is therefore the spot price plus interest accrued and payable to existing bondholder for the elapsed 60 days of the accrual period consisting of the sum of 60 and 122 days shown on the left side of the diagram:
It is usually assumed that the dividends provide a known yield rather than a known cash income. If q is the dividend yield, then the futures price is given by:
In this case, r = 0.06, S = 7,220, q = 0.02, and T = 0.25. Hence, futures price, F, is given by F = 7,220 x ee(0.06-0.02) x 0.25 = 7,292.5. Now, that is a lot easier to calculate than bond futures, isn't it?
However, arbitrage operations will ensure that the actual futures prices quoted do not differ too much from their theoretical values. It is mainly differences in impact costs that lead to differences between the theoretical prices and actual futures prices quoted.
The actual futures prices quoted are split into bid (buying) and offer (selling) prices. Investors always buy at the higher price and sell at the lower price to dealers, while futures dealers buy at their bid price, which is always lower than their offer price. The difference between the bid and offer price is the profit margin for the dealer.
-- Contracts are traded either by open outcry on a centralised exchange or on electronic exchanges (ie exchanges without a centralised floor, using automated trading systems, through which transactions take place by means of a computer network);
-- Contracts are highly standardised, with trading in specific months for specific quantities of products;
-- Underlying commodities or financial securities are delivered through a clearing system, and the clearing house guarantees the fulfilment of contracts entered into by clearing members;
-- Actual delivery against futures contracts tends to be rare;
-- Liquidity has to be high for a futures contract or such a contract tends to "die";
-- Trading costs tend to be relatively low;
-- All futures contract prices are publicly disclosed; and
-- Profits and losses on futures contracts have to be settled daily (mark-to-market).
The aim of all these regulations is to reduce the transaction and information costs for standard types of contracts.
For this group, regulators allow futures exchanges to set low margin requirements for trading positions, often in the range of 0-15%.
A speculator accepts the risks of adverse price changes, thereby allowing the hedger to reduce his or her risks at the cost of forsaking any potential profits to be gained from favourable price movements. Speculators are confined mainly to brokers and professional traders.
Since most speculative activity is based on naked or one-sided positions, exchanges usually levy heavy margins on this group...often ranging to as high as 50%.
Usually arbitrage operations account for about half of all trade in the futures markets. Because arbitrage by definition is a covered trade, exchange margins are set at zero.
(Concluded)