Convenience yield

A convenience yield is an adjustment to the cost of carry in the non -arbitrage pricing formula for forward prices in markets with trading constraints.

Let Ft,T be the forward price of an asset with initial price St and maturity T. Suppose that r is the continuously compounded interest rate for one year. Then, the non-arbitrage pricing formula should be

Ft,T = Ster(T − t).

However, this relationship does not hold in most commodity markets, partly because of the inability of investors and speculators to short the underlying asset, St. Instead, there is a correction to the forward pricing formula given by the convenience yield c. Hence

Ft,T = Ste(r − c)(T − t).

This makes it possible for backwardation to be observable.

Example: A trader in derivatives market, has observed that the price of 6 month gold futures price is Rs.12,000 per 10 grams and the spot price is Rs.13,710 per 10 grams. The annualized borrowing rate is 12.5% and storage cost is negligible. In this regard, the convenience yield:



12000 = 13710 + (13710 x 0.125 x 6/12 - convenience yield)

CY = Rs. 2566.875; as a percentage of spot price = 18.72%