Question

If the net convenience yield is lower than 100% but higher than the risk free rate

Group of answer choices

The future rate for a commodity should be higher than the spot price of the commodity.

The future rate should be negative

The future rate of the commodity will converge to zero as the maturity of the contract goes to infinity.

None of the above.

Answer 1

Ans: The Future Rate should be Negative

What is a Convenience Yield?

A convenience yield is the benefit or premium associated with holding an underlying product or physical good, rather than the associated derivative security or contract.

Sometimes, as the result of irregular market movements such as an inverted market, the holding of an underlying good or security may become more profitable than owning the contract or derivative instrument due to its relative scarcity versus high demand. Consider purchasing physical bales of wheat rather than wheat future contracts. If there’s a sudden drought, and the need for wheat increases, the difference between the first purchase price of the wheat versus the price after the shock would be the convenience yield.

Convenience Yield Explained

The storage of a physical good or commodity closely relates to the convenience yield of products. However, there’s an inverse correlation between commodity prices and storage levels. Based on the levels of supply and demand, when storage levels of a commodity are scarce, the commodity's price tends to rise. The opposite is also true; when a commodity's storage levels are plentiful, the price typically decreases.

Convenience yields tend to exist when the costs associated with physical storage, such as warehousing, insurance, security, etc., are relatively low.