Convenience yield
Convenience yield is the additional yield an investor can obtain from holding a physical commodity and storing it, as opposed to buying and selling the futures contract associated with that commodity. This yield can be calculated by subtracting the futures price from the spot price of the commodity.
For example, an investor who purchases corn at the spot price and stores it for a period of time will realize a convenience yield if the price of the corn futures contract decreases during that period. This is because the investor can sell the corn at the spot price and still realize a profit, even though the price of the corn futures contract has decreased.
Example of Convenience yield
An example of a convenience yield can be seen in the corn market. If an investor purchased corn at a spot price of $4 per bushel and the price of the corn futures contract decreased to $3.50 per bushel, the convenience yield for that investor would be $0.50 per bushel. This is because the investor can still sell the corn at the spot price of $4 and realize a profit of $0.50 per bushel.
In conclusion, convenience yield can be seen in the corn market when an investor purchases corn at a spot price and the price of the corn futures contract decreases. The convenience yield for that investor is then calculated by subtracting the futures price from the spot price of the commodity.
Formula of Convenience yield
The formula used to calculate the convenience yield is as follows:
- Convenience Yield = Spot Price - Futures Price
Therefore, the convenience yield is essentially the difference between the spot price and the futures price of a particular commodity. The higher the convenience yield, the greater the return for the investor who holds the physical commodity and stores it, as opposed to buying and selling the contract associated with that commodity.
When to use Convenience yield
Convenience yield can be used when an investor is looking to purchase a commodity and store it for a period of time. By storing the commodity, the investor would be able to realize a profit if the price of the commodity’s futures contract decreases during that period. This is because the investor can sell the commodity at the spot price, which is higher than the futures price. Additionally, convenience yield can be used when an investor is looking to hedge against a potential decrease in the commodity’s price.
Types of Convenience yield
Convenience yield can be broken down into two distinct types, namely, time convenience yield and storage convenience yield.
Time convenience yield is the yield an investor earns from holding a physical commodity for a certain period of time. This yield is calculated by subtracting the spot price of the commodity from the price of the futures contract associated with the commodity at the time the investor holds the commodity.
Storage convenience yield is the yield an investor earns from storing the physical commodity. This yield is calculated by subtracting the spot price of the commodity from the price of the futures contract associated with the commodity at the time the investor intends to sell the commodity.
Advantages of Convenience yield
There are several advantages to using convenience yield. These include:
- It can provide a hedge against price volatility as the investor is able to take advantage of spot price changes.
- It can also be used to take advantage of arbitrage opportunities by simultaneously buying the physical commodity and selling the futures contract.
- It can also be used to speculate on the future price of a commodity, as the investor can buy the physical commodity and wait for the price to increase.
Limitations of Convenience yield
Despite being a useful tool for investors, there are a few limitations to the convenience yield.
- The calculation of convenience yield assumes that the price of the futures contract and the spot price will be the same in the future, which can be a risky assumption.
- While the convenience yield is a useful tool for investors, it does not account for the cost of storage and the opportunity cost of capital.
- The convenience yield does not take into account the risk of storage, such as spoilage or theft.
In addition to the traditional approach to calculating convenience yield, there are other methods that can be used to estimate the potential yield of a commodity. These include:
- The Contango Model: This model uses the difference between spot and futures prices to estimate the potential yield of a commodity. It assumes that the spot price of the commodity will increase at a rate equal to the difference between the spot and futures prices.
- The Interest Rate Model: This model uses the correlation between interest rates and spot prices to estimate the potential yield of a commodity. It assumes that when interest rates increase, the spot price of the commodity will also increase.
- The Risk Premium Model: This model uses the risk associated with holding a commodity to estimate the potential yield of a commodity. It assumes that investors will require a higher return for holding a commodity with greater risk.
In conclusion, in addition to the traditional approach to calculating convenience yield, there are other methods that can be used to estimate the potential yield of a commodity. These include the Contango Model, Interest Rate Model and Risk Premium Model.
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References
- Brennan, D., Williams, J., & Wright, B. D. (1997). Convenience yield without the convenience: a spatial-temporal interpretation of storage under backwardation. The Economic Journal, 107(443), 1009-1022.
- Casassus, J., & Collin‐Dufresne, P. (2005). Stochastic convenience yield implied from commodity futures and interest rates. The Journal of Finance, 60(5), 2283-2331.
- Gospodinov, N., & Ng, S. (2013). Commodity prices, convenience yields, and inflation. Review of Economics and Statistics, 95(1), 206-219.
