Convenience Yield and Backwardation in Physical Commodity Markets
Summary
The explanation distinguishes the cost of carry from convenience yield in commodity futures pricing. Carry costs, such as the expense of holding inventory, make physical ownership less attractive. Convenience yield works in the other direction: it represents the practical benefit of having the commodity available for immediate use, even when storage or financing costs are unfavorable.
A copper tube factory illustrates why futures may not replace spot inventory for every buyer. A factory needs physical copper to keep production running; a futures contract cannot be fed into its machinery. The futures price can signal that firms should limit inventory to immediate needs, but they still must hold some stock. This offers intuition for backwardation when access to physical supply is valuable. The discussion is conceptual and provides no pricing formula or empirical test; it also does not quantify how convenience yield varies across commodities or market conditions.
Key ideas
- Cost of carry reduces the appeal of holding physical inventory, while convenience yield increases it.
- A consumer may value immediate access to a commodity even when a futures contract is cheaper.
- Futures cannot always substitute for physical inventory required in an operating process.
- Convenience yield can help explain backwardation when commodity users place high value on available supply.
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# Convenience yield intuition on consumption assets? # Convenience yield intuition on consumption assets? Something I'm having difficulty wrapping my head around is the argument that commodity futures can be in backwardation due to a large convenience yield, for example "to keep a production process running". When I think of the cost of carry, I think of it intuitively as what costs the party long the asset incurs by holding the asset to expiry. The costlier it is for the holder of the asset during this time to expiry, the higher the forward price. I'm having trouble seeing how the person that is "holding onto" the asset until expiry can just decide to consume the commodity if needed and that provides value. For example, if I'm short forward and long the commodity in a cash-and-carry arb, I can consume the commodity, but I have to buy it back later in order to close out my short position. So I don't see any value of being able to consume the commodity given that I'll have to buy it back then to close out my cash and carry. ## Answer by nbbo2 (score 1) https://quant.stackexchange.com/a/78190 You mention Cost of Carry and Convenience Yield as if they are similar. Actually Cost of Carry and Convenience Yield work in opposite directions. CoC makes the holding of a physical commodity less attractive than it would otherwise be. CY makes holding the commodity more attractive despite other factors that are not favorable. In a situation where it does not make sense to hold the commodity and it would even be a good idea to short it, but people do not do so, it must be [according to economic theory] because of some CY that people receive. Suppose copper is available for future delivery in 3 months at a price much lower than today's spot price. Who are the idiots who buy spot copper instead of buying the future? They are not idiots, they are people who own a copper tube manufacturing factory and need copper to use in their plant during the next 3 months. For them spot copper has a "convenience yield", for them futures are not a substitute for the spot commodity (they can't tell the workers: "put some futures in the machine today, we have run out of copper and I only have futures."). Because of the "signal" from the Futures Markets these people will operate "from hand to mouth" buying as little copper as possible to cover immediate needs, but they still need to buy copper.
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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.