Can some one help me understand this LOS–what it is looking for? It is very confusing in the CFAI and Schweser books… how would you answer the LOS below? Thanks identify and explain the arbitrage situations which arise as a result of the convenience yield of a commodity and commodity spreads;
Just went through both and it seems like Schweser isn’t doing a good job in explaining why there is an arbitrage opportunity and why there is a no-arbitrage range, rather than a no-arbitrage price. Essentially what you need to learn is how to arbitrage using a cash-and-carry / reverse cash-and-carry trade. Also, you need to that not everyone can have a convenience yield (generally only businesses that utilize the commodity). Cash and Carry: If the Futures price is greater than the spot price compounded continuously at the risk free rate and plus storage costs, then you can earn an arbitrage profit by selling the futures contract and buying the commodity. You get cash from selling the contract, and you carry (store) the goods until delivery. Reverse cash and carry: If the Futures Price is less than the spot rate compounded continuously at the risk free rate, plus storage costs, AND less a convenience yield, then you can earn an arbitrage profit by borrowing the asset, leasing it out it until delivery, and buying a futures contract. (I still need to wrap my head around this trade a little more…) The reason there is a range in the no-arbitrage price is because there is a spectrum of different people/businesses who can do this trade. Those who have a convenience yield are on one side while individual investors are on the other.
ymmt Wrote: ------------------------------------------------------- > > Reverse cash and carry: If the Futures Price is > less than the spot rate compounded continuously at > the risk free rate, plus storage costs, AND less a > convenience yield, then you can earn an arbitrage > profit by borrowing the asset, leasing it out it > until delivery, and buying a futures contract. (I > still need to wrap my head around this trade a > little more…) > That’s right, but to help you get your head around it a little more - The reverse cash and carry is not nearly as easy to do as the cash and carry, because borrowing a commodity and selling it doesn’t work too well (“Sir can I borrow your pigs to sell? I promise I will return them.” or “Could I borrow 50,000 tons of copper and I will return 50,000 tons of copper to you later?”). There are just too many practical problems with borrowing commodities for this to work very often. It works fine with something like gold (which people borrow all the time) because you just have to return similar gold, not the same atoms. The absence of the reverse cash and carry means that there might not be an arbitrage to keep the futures price up and then you have a big convenience yield. For example, copper can sell much higher in the spot market than in the futures markets for later delivery and there just is no reverse cash and carry.