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What Is a Convenience Yield Definition and How to Calculate

What Is a Convenience Yield Definition and How to Calculate

What Is a Convenience Yield? Definition and Calculation

Tim Smith has over 20 years of experience in the financial services industry, as both a writer and trader.

What is a Convenience Yield?

A convenience yield is the benefit or premium of holding an underlying product or physical good over the associated derivative security or contract.

In certain market movements, like an inverted market, holding the physical good or security can be more profitable due to its relative scarcity compared to high demand. For example, purchasing physical bales of wheat instead of wheat future contracts can result in a convenience yield if there’s a sudden drought and the need for wheat increases. The difference between the initial purchase price and the price after the shock represents the convenience yield.

Convenience Yield Explained

Convenience yield is closely related to the storage of physical goods or commodities. Commodity prices and storage levels have an inverse correlation, with prices rising when storage levels are scarce and decreasing when storage levels are plentiful.

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

Convenience Yield and Cost of Insurance

Investors can calculate the convenience yield as the cost of insurance against price risk. The formula involves multiplying the price of a front-month futures contract by the capital cost of money tied up in inventory, adding the storage cost, and subtracting the price of the back-month futures contract. This calculation is then divided by the price of the front-month futures contract, with one added to the quotient. The resulting value is then raised to the power of 365 divided by the number of days to maturity, and finally, subtracting one from the resulting value.

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Key Takeaways

  • A convenience yield is a premium associated with holding an underlying asset, instead of the associated derivative security or contract.
  • Convenience yields typically arise when costs associated with physical storage are low.
  • Investors need the commodity’s future price, spot price, borrowing rate, and time to maturity to calculate the convenience yield.

Real World Example of Convenience Yield

Calculating the convenience yield is straightforward if the commodity’s future price, spot price, borrowing rate, and time to maturity are known. The formula uses the spot price, futures price, borrowing rate, and convenience yield to arrive at the convenience yield value.

For example, let’s calculate the convenience yield of West Texas Intermediate (WTI) crude oil for delivery one year from today. Assuming an annual borrowing rate of 2%, a spot price of $50.50, and a futures price of $45.50 for crude oil contracts expiring one year from today, the convenience yield is 12.43% continuously compounded per year, calculated as 0.02 – (1/1) * LN($45.50/$50.50).

For example, let’s calculate the convenience yield of West Texas Intermediate (WTI) crude oil for delivery one year from today. Assuming an annual borrowing rate of 2%, a spot price of $50.50, and a futures price of $45.50 for crude oil contracts expiring one year from today, the convenience yield is 12.43% continuously compounded per year, calculated as 0.02 – (1/1) * LN($45.50/$50.50).

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