Commodities - Alternative investment

CFA Level II Alternative Investments
#1

Hello,
hope this is not a too stupid question as it is my first post here…

reference: CFA level 2 - Alternative investment - reading 42 - p. 3.3.1.3

Convenience yield is inversely related to inventory availability / supply, i.e the higher the supply or inventory availability, the lower the convenience yield to carry the commodity.
When there is for example short supply of Oil the spot price increases and the convenience yield should increase. Given the formula future price= spot price + cost of carry - convenience yield the future price should decrease (because of higher convenience yield which is negative related (-) to the future price)… does this make sense? I mean that if in the future there is not view of increasing supply, shouldn’t the future price of Oil increase of value too?

Clearly I am missing something big which now I do not get it…

#2

Greetings friend! Here is a nice article on convenience yields if you are interested:
https://www.sr-sv.com/understanding-convenience-yields/

Think of convenience yield as the value gained from holding inventory. This value can come from its usable nature (such as in the oil industry as described in the article above) or because of scarcity etc. As you correctly point out, low supply generally means higher convenience yield.

The person who possesses the commodity benefits from the convenience yield. This is why it is factored to the spot price and not the futures price, because the spot buyer/seller has the commodity. If you buy a future contract, you do not get immediate delivery. Someone else is holding it. So you don’t benefit from convenience yield and are, depending on the date of your futures contract, possibly far away from receiving the benefit of possession currently.

So if there is a high convenience yield, then all other things being equal the market will be in backwardation. Future prices will be below spot prices. So let’s take a second and think about what that means. It doesn’t mean that in the future oil prices will be cheap. It means buying a long-dated future on oil is a cheaper way to buy oil if you can wait it out and don’t need it now.

What is backwardation? It is when farther out future prices get increasingly cheaper versus today’s spot price. And this allows you to get positive roll yield (you make money rolling futures). Why do you make money rolling futures? Because each month your long-dated futures are getting a month closer to the spot date. And spot prices are higher than future prices. This means, in September, your futures contract for October delivery of commodity X that you bought cheap in January is now approaching its delivery date and approaching the spot price. You can sell it now for more than you bought it for originally because due to backwardation as time passes and future delivery dates approach the spot date, the originally cheaper futures contracts are now approaching the higher spot contract price because they are no longer far away deliveries. They are close to spot deliveries. And - you are close to being the beneficiary of the convenience yield as a spot holder in such case.

So your price is gradually converging from lower far-away future delivery pricing to higher spot pricing which then conveys convenience yield to you once you buy and take delivery. The gradual price increase as your possession time approaches, in a market that’s in backwardation, is partially explained by the convenience yield becoming closer and closer to being conveyed with the contract and the implied benefit of ownership therefore is increasingly factored into the price.

Does this help?

Cheers - good luck - you got this👍

2 Likes
#3

Croissants taste better when you make them with flour than with flour futures contracts.

2 Likes
#4

If you’re long the futures.

Short has negative roll yield in backwardation.

2 Likes
#5

Absolutely correct as usual👍

#6

This is an impressive reply.

THANK YOU.

Now I see the whole concept with different eyes. Again, fascinated with all the paragraphs and the structural logic behind it and how easily it was explained.

1 Like
#7

My pleasure - this is my goal here on AF - to explain and empower folks to the best of my ability. I’m human and I don’t always achieve this, but it’s always my motivating goal when I respond to questions.

Cheers - good luck - you got this👍

1 Like
#8

But won’t the contracts make the croissants heavy and chewy instead of buttery and flaky???

#9

You mean bad inventory ? :joy:
Storability vs Perishability …… makes sense ?:stuck_out_tongue_winking_eye::rofl:

Only if S - P has positive value CV would kick in.

Magician is cheeky always. Don’t believe much in him​:rofl::rofl::rofl::rofl:( Pun INTENDED). He had to bring in the :croissant: thing

1 Like
#10

Elder… very good job in explaining threadbare.

1 Like