Convenience yield

Owning a share and owning a futures contract on that share are, economically, close to the same thing. Owning a tonne of crude and owning a crude future is not.

A refinery that runs out of crude stops. A food processor that runs out of raw material stops. Physical stock keeps the production line moving, and that is worth money even though it never appears on a price screen. Convenience yield is that benefit, expressed in rupees.

The workbook is explicit that this is one of the features separating commodity derivatives from financial derivatives: a bond or a stock in the vault adds nothing that a futures contract on it does not.

Convenience yield behaves like a negative carrying cost, so it enters the futures pricing equation with a minus sign:

F = S + C - Y

It rises when supply is tight and falls when supply is comfortable. The workbook lists what pushes it up: continuous production processes, uncertainty of supply, the lean season in agriculture, scarcity, and a manufacturer's preference for one particular supplier who also holds stock until it is called for. It even counts plain lack of awareness of the futures market as a source, since a buyer who does not know futures exist will buy spot and block the full purchase value.

The visible consequence is on the curve. As convenience yield rises, the gap between futures and spot narrows — and once Y exceeds C, the futures price falls below spot and the market is backwardated.

F = S + C - Y

F : Futures price
S : Spot price
C : Cost of carry  (finance + storage + insurance)
Y : Convenience yield

Set Y = 0 and this collapses back to the plain cost-of-carry model F = S + C, which is why financial futures need no convenience yield term.

The workbook's guar seed farmer, priced out in full.

A farmer has just harvested. Spot guar seed is Rs 6,000 per quintal. He can sell now or store for six months.

Because the convenience yield of Rs 300 exceeds the Rs 200 of storage cost and risk, holding the crop is economically worth it — the farmer is being paid Rs 100 a quintal, in convenience, to keep stock available for a market that may need it during the lean season.

On 100 quintals (10 MT) that is Rs 30,000 of convenience yield against Rs 20,000 of storage cost — Rs 10,000 net, before any view on where prices go.

And on the futures curve the same Rs 300 shows up as price: six-month futures at 6,000 + 200 − 300 = Rs 5,900, a hundred rupees below spot.

Chapter 3 (Commodity Futures), section 3.6, which is devoted to it and closes by rewriting the cost-of-carry equation as F = S + C - Y. Chapter 2 uses it to explain why an index constituent can go into sharp backwardation. The questions that come from it are conceptual — what distinguishes a commodity future from a financial future, why a processor holds inventory above immediate need, what happens to the futures-spot gap when convenience yield rises — plus straight application of the F = S + C - Y form.

• It is subtracted, not added. F = S + C - Y. Adding it is the single most common error in this section.
• It is not a storage cost and not a profit. It is the benefit of having the goods on hand, and it is measured in rupees per unit for a stated period.
• Financial futures have no convenience yield. Holding the bond or the stock gives you nothing the future does not. This is the examinable difference between commodity and financial derivatives.
• High convenience yield narrows the futures-spot gap, and if it exceeds the cost of carry it flips the market into backwardation.
• It is not observable. It is backed out of the prices, which is why the workbook calls its guar seed figure an estimate.
• Scarcity raises it; comfortable supply lowers it. A question describing a glut and asking for a rising convenience yield is testing exactly this.