As far as I understand, the Convenience Yield is the value of having the physical commodity for use now, over the period of the futures contract.
If the convenience yield is high, futures price > spot price, resulting in contango.
If the convenience yield is low, futures price < spot price, resulting in backwardation.
Where I’m confused:
If the convenience yield is the value of having the physical commodity now, why would the futures price be higher than the spot if the CY is high? Wouldn’t the spot price be higher since it’s more valuable to hold it physically now?
Vice versa for backwardation. Also, why would the roll yield be + in backwardation, while - in contango?
High convenience yield lowers the futures price: a baker is going to pay more for flour than for futures on flour; futures contracts do not make for tasty croissants.
Roll yield is when you make money selling your futures near to expiry and roll them into longer-term futures. In backwardation, the spot prices and near term future prices are higher than the far term ones. Another way to look at it is to say as futures contracts become “closer to now” they will increase in value because your contract is always moving “right to left” as time passes and what was once a far away futures contract slowly approaches the spot market time (starting on the cheaper right side of the backwardation curve and slowly becoming nearer and nearer term, approaching the spot when you get near expiry). Therefore by buying futures far down the right side of the backwardation curve and holding them from inception to near expiry, you’ve bought lower (they begin farther away at a “lower price” and you then sell them higher when you later roll them near expiry (they are now close to the higher spot rate part of the curve and have gained in value relative to when you bought them).
So you can profit by selling them and rolling into longer term futures, in a backwardated market. You bought low and sold high. Positive roll yield.
It’s the opposite for contango. Roll yield is negative because as your contract moves “right to left” on the futures price curve with the passage of time, your contract value is decreasing. Because farther away futures are more valuable than nearer-term ones or the spot rate. And with time your futures contract is getting nearer term and approaching spot. When you roll it to buy new longer term futures, you are “selling low to buy high” and have negative roll yield.
If convenience yield is high, it means spot prices are higher than longer term future prices. The market is in backwardation.
First, make sure that you realize that this comment refers to roll yield for the long position; the roll yield for the short position is the negative of the roll yield for the long.
Second, make sure that you realize that this isn’t always true. There are assumptions made that are necessary for this to be true, but nobody ever tells you what those assumptions are.
Roll yield should be a very easy idea to grasp. Unfortunately, finance people have done yeoman’s work to ensure that it isn’t, starting with an utter lack of agreement on how roll yield is calculated.
