What is a Convenience Yield
A convenience yield is the benefit or premium associated with holding an underlying product or physical good, rather than the associated derivative security or contract.
Sometimes, as the result of irregular market movements such as an inverted market, the holding of an underlying good or security may become more profitable than owning the contract or derivative instrument due to its relative scarcity versus high demand. An example would be purchasing physical bales of wheat rather than wheat future contracts. If there is a sudden drought, and the demand for wheat increases, the difference between the first purchase price of the wheat versus the price after the shock would be the convenience yield.
BREAKING DOWN Convenience Yield
The storage of a physical good or commodity is closely related to the convenience yield of products. However, there is an inverse correlation between commodity prices and storage levels. Based on the levels of supply and demand, when storage levels of a commodity are scarce, the commodity's price tends to rise. The opposite is also true; when a commodity's storage levels are plentiful, the price tends to decrease.
Convenience yields tend to exist when the costs associated with physical storage, such as warehousing, insurance, security, etc., are relatively low.
Convenience Yield Example
The convenience yield is simple to calculate if a commodity's future price, spot price, borrowing rate and time to maturity are known. The futures price is calculated as the spot price multiplied by Euler's number, or the mathematical constant e, raised to the power of the difference between the borrowing rate and the convenience yield multiplied by the time to maturity. Consequently, the convenience yield is solved to be the difference between the borrowing rate and one divided by the time to maturity multiplied by natural log of the futures price divided by the spot price. This formula is used for continuously compounding rates and yields.
For example, assume that a trader wishes to calculate the convenience yield of West Texas Intermediate (WTI) crude oil for delivery one year from today. Assume that the annual borrowing rate is 2 percent, the spot price of WTI crude oil is $50.50 and the futures price of crude oil contracts expiring one year from today is $45.50. Therefore, the convenience yield is calculated to be 12.43 percent continuously compounded per year, or 0.02 - (1/1) * LN($45.50/$50.50).
Cost of Insurance
The convenience yield could also be calculated as the cost of insurance against price risk. The formula is calculated by multiplying the price of a front month futures contract by the capital cost of money that is tied up in inventory, or Euler's number raised to the borrowing rate multiplied by the time to maturity, then adding the storage cost and subtracting the price of the futures contract for the back month contract. Next, divide this calculation by the price of the front month futures contract and add one to the quotient. The resulting value is raised to the power of 365 divided by the number of days to maturity. Finally, subtract one from the resulting value.