Convenience Yield

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doobsmeister

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“The Theory of storage explains that there is an inverse relationship between inventories and commodity futures prices: the higher inventories are, the lower the convenience yield will be, and thuse the lower the futures price will be”
Why does it mean that the convenience yield is lower when inventory is abundant?
 
It sounds to me like a law-of-diminishing-marginal-utility thingy: if you already have 100,000 lbs. of cake flour in the pantry in your bakery, you’re not going to ascribe much value (convenience yield) to the 100,001st lb.
 
well said magician. thanks. Will remember the cake flour in the pantry if this is asked in the exam ;)
 
I understand the way you look at it
But thinking this way - higher the level of inventories, lower the convenience yield, and going by the formula
future price = spot price*e^(r+U-Y)T,
The futures price will be higher with lower convenience yield/high level of inventories
I believe there should be a direct relationship and not inverse relationship between the two.
Please help!
Thanks in advance!:)
 
I believe a higher convenience yield means there is less supply/price risk and thus a lower futures price. To me, this sounds similar to the concept of a coupon bond future or equity index future having a lower price if it pays dividends.
 
jcjc0602 wrote:
I also think it’s a direct relationship!! Help!!
Click to expand...
If a bakers has 100k pounds flour in their warehouse and only need 50k for production over the next month, this means they won’t need more flour in the next period, which equates to lower demand and thus lower futures price.
 
Thanks for your reply!
So you mean in this case convenience yield is low and then future price is low. therefore, the convenience yield in this case is not equivalent to the Y, which is also called “convenience yield”, in equation:
future price = spot price*e^(r+U-Y)T
is that right?
 
So does that mean that the theory of storage implies that the relationship future price = spot price * e^(r+U-Y)T does not hold?
If inventory is high, then the convenience yield is low and the future price is high, hence a direct relationship between inventory levels and future price according to the function.
However, the theory of storage says otherwise; inventory levels are inversely related to future price.
 
Schweser, Book 4. page 146 - Key concepts LOS 44.c
higher the level of inventories, lower the convenience yield. And thus the lower the futures prices will be.
I think Schweser is wrong?
 
FrankCFA wrote:
Schweser, Book 4. page 146 - Key concepts LOS 44.c
higher the level of inventories, lower the convenience yield. And thus the lower the futures prices will be.
I think Schweser is wrong?
Click to expand...
Although poorly worded by Schweser, they imply that someone with an abundance of inventory does not find 1 additional unit of inventory more valuable. Therefore, having more on hand, yields less value to the future inventory, thus future price. I think this theory makes a lot of sense.
In terms of the equation, I always think of someone who has more inventory on hand to have a lower convinence yeild, which means ‘Y’ is higher. Think of it as U-Y, where the convience yeild is the spread between the cost of storage and the implicit value they receive from having this inventory on hand.
If the spread is “smaller”, the convience yield is low and Y is high.
If the spread is “wider”, the convience yield is high and ‘Y’ is low.
 
Thanks. lower convenience yeild, which means ‘Y’ is higher??
So convenience yeild = -Y ? Thanks.
 
Higher inventory will make the spot price fall quickly than future price. (higher future price)
So i think Schweser is wrong
higher the level of inventories, lower the convenience yield. And thus the higher the futures prices will be.
 
Although your reasoning seems sound, Schweser says that convenience yield is Y in the function; not the spread between U and Y as in your example.
So if convenience yield is Y, a higher inventory will have a lower convenience yield, which translates to a higher future price.
 
yes, agree. And inventory will make the spot price fall quickly than future price as well.
So conclustions are:
- Future price will hgiher than spot price. In terms of equation, F=S*e^(r+U-Y) is still valid. Lower Y => Higher F than S.
- But in absoulte term, new future price will lower than previous future price. (As mentioned by many friends above)
 
It’s just what magician said.. When you have a lot of inventory, the items are not as valuable to hold, hence you get “less yield” holding them since they are not as valuable to you, and since they are not as valuable to you, the futures price will be higher since the person buying the futures is not “missing out” from the yields (which are extremely low) of holding the inventory.
 
just noticed this from schweser website, fyi.

Book: 4 - Errata Reporting

Page: 146 - Reading 44 Key Concepts - Theory of Storage
Change the second paragraph of the Key Concept for LOS 44.c to read: “The theory of storage explains that there is an inverse relationship between inventories and CONVENIENCE YIELD: the higher inventories are, the lower the convenience yield will be, and thus the HIGHER futures prices will be RELATIVE TO SPOT PRICES.” ( Posted: 2014-03-25)
 
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