This is not the only thing i struggle with when i read the commodity chapter. But let’s start with this one. Regarding real option (producers’option to produce or not produce the commodity) the CFAI material states “production only occurs if discounted futures prices are below spot prices”. I don’t understand that one. Neither what is convenience yield (just to mention another one…). Thanks guys!
Convenience yield is the benefit of holding the asset.
If the benefit of holding the asset is higher than the risk free rate, the investor will hold the asset. Why? Because if they sell the asset and invest in risk free asset, their future payout will be lower than the convenience yield.
Production occurs only in backwarded markets, when convenience yield is sufficiently high.
Ok i am sure your explanation is straightforward. I am just totally out on commodities in general. Will need to review basics first, then i’ll come back to your explanation. Thanks a lot!
It refers to nonmonetary benefits from owning the spot commodity.
If the spot price is $10 and the PV of the futures price is $9, you’re better off producing and selling today.
If the spot price is $10 and the PV of the futures price is $11, you’re better off producing and selling in the future.
Benefit from holding a commodity.
A baker waking up at 3:00AM to make donuts and croissant and whatever for the on-the-way-to-work breakfast crowd is much better off having 100 lbs of flour in inventory than having a futures contract on 100 lbs of flour; that’s convenience yield.