Convenience Yield

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21 Aug, 2024

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Convenience Yield is the benefit of holding an asset physically rather than as a futures contract. It is associated with physical goods kept as inventory, and is also linked to consumable products generally used by people.

The utility of convenience yield is the premium that an individual or entity realizes by holding the asset and using it for its advantage by controlling its supply in times of varying demand, especially in shortage. It typically increases when the asset has a low storage cost. Consequently, the net convenience yield directly influences an investor's overall return on investment.

What Is Convenience Yield?

Convenience yield is the premium that an investor realizes by holding an asset instead of trading its futures contract.
It is primarily associated with commodities and consumable products and not monetary investments.
It is a critical indicator for gauging future prices, predicting market conditions, and predicting inventory costs.
It changes with irregular market conditions, and it is also possible that holding an asset would be expensive for an investor compared to having it in a futures contract or derivative instrument.

Convenience Yield Explained

Convenience yield involves retaining possession of a physical asset, consumable product, or commodity instead of opting for a futures contract. In contrast, a futures contract is a pact between two parties (buyer and seller) to exchange goods for a predetermined payment on a specified date. If two parties engage in a futures contract for any physical commodity, and upon the contract's expiration, the spot price exceeds the futures price due to the agreement, it results in a loss for the seller. This loss is binding because the contract obligates the involved parties.

Unlike a futures contract, which is an agreement to exchange goods for a fixed payment on a predetermined date, it is about the advantage of possessing the physical asset itself. For instance, consider a futures contract for a commodity where the spot price (current price) at the time of delivery is higher than the futures price (pre-agreed price). In this scenario, it's advantageous for the seller of the futures contract, not a loss, as previously stated. Conversely, if the spot price is lower than the futures price, it's beneficial for the buyer of the futures contract.

Additionally, there's the factor of cost of carry, which refers to the expenses incurred by an investor to maintain a commodity position. It emphasizes that the cost of carrying isn't directly observable but is intricately associated with the yield and the type of commodity that an investor chooses to hold as inventory.

How To Calculate?

The convenience yield is calculated as the difference between the borrowing rate and the continuously compounded yield derived from the difference between the futures price and the spot price, adjusted for the time to maturity. Let's understand it further with the help of the convenience yield formula below:

Here,

Borrowing Rate: This represents the interest rate at which investors can borrow funds. It is the cost associated with financing the purchase of the commodity.
Time to Maturity: This refers to the remaining time until the futures contract expires. It's typically measured in years. The reciprocal of the time to maturity (1 divided by the time to maturity) is used in the calculation.
Natural Logarithm (ln): The natural logarithm function (denoted as ln) is a mathematical function used to find the continuously compounded yield. It's applied to the ratio of the futures price to the spot price.
Futures Price and Spot Price: These are the prices of the commodity agreed upon in the futures contract and the current market price of the commodity, respectively. The difference between these prices reflects the market's expectation of future supply and demand dynamics.

Examples

Let us understand the concept with the help of some hypothetical and real-world examples.

Example #1

Suppose Anthony is a crude oil investor; suppose he purchased 72 oil barrels at $9 per container, investing $648. He had the choice of getting involved in a futures contract. Still, Anthony decided against it and stored the oil barrels. Now, the price of the oil's futures contract has declined to $8.1 per container. Let's assume that the borrowing rate is 2% and the time to maturity is one year.

Using these assumptions, we can calculate it using the following formula:

This calculation yields a negative convenience yield, indicating that Anthony would incur a loss by holding onto the physical commodity rather than entering into a futures contract, considering the borrowing rate and the difference between spot and futures prices.

Therefore, while Anthony may still sell the oil barrels at $9 per barrel, he would be better off entering into a futures contract, given the current market conditions.

Example #2

In a study about crude oil markets, researchers looked at data from 2001 to 2010 to understand how convenience yield changes over time. They found that sudden price jumps in oil prices throughout the day had a significant impact on convenience yield. Specifically, they discovered that when oil prices jumped a lot one day, it affected how much investors benefited from holding onto oil instead of selling it.

By looking at factors like how much oil was in storage and how prices changed over several weeks, the researchers were able to predict better how convenience yield would change. This information helps investors and policymakers make smarter decisions about buying and selling oil.

Convenience Yield vs Collateral Yield

Understanding the distinctions between convenience and collateral yield is crucial in comprehending the diverse dynamics of commodity markets and financial derivatives.

It is the benefit of holding an asset against future contracts. In comparison, collateral yield is the gain that appears when putting aside collateral in future contracts.
While holding the physical asset may provide opportunities to benefit from market movements, it does not directly enable control over market prices. Investors with futures contracts can also benefit from market movements through trading strategies.
It encompasses various factors such as storage costs, scarcity, and immediate usability of the asset. Collateral yield, on the other hand, is the interest earned on the collateral submitted.

Frequently Asked Questions (FAQs)

Why is the convenience yield important?

The importance of this concept is -
a. It allows an investor to take advantage of the price mismatch.
b. Holding the physical asset against a futures contract brings a premium.
c. Based on its value, an investor can predict future market conditions.

Is the convenience yield positive or negative?

It can be both positive and negative. Typically, when focusing on physical commodities, it is expected to be positive because, in case it becomes negative, there is always an arbitrage opportunity for an investor to sell the goods in the future at a different, higher price.

What happens when convenience yield increases?

When in an active market, there occurs a mismatch between the supply and demand of any commodity or physical good, and scarcity gets developed in spot markets, which leads to a rise or increase. When this happens, spot prices grow higher than future prices, and this phenomenon is also referred to as backwardation.