Why is the convenience yield (y) greater than the cost of carry (c) in backwardation?

[DTu]

150.1. If the forward curve for a consumption commodity exhibits backwardation, when should the short position in a futures contract elect to make physical delivery?
a. It makes no difference when, as long as the short delivers within the allowable period
b. The short does not have a choice as delivery must be made on the DELIVERY DAY
c. The short should delivery as early as possible after the FIRST NOTICE DAY
d. The short should deliver as late as possible but before the LAST TRADING DAY

150.1. D. The short should deliver as late as possible but before the LAST TRADING DAY
In backwardation, the convenience yield (y) is greater than the cost of carry (c) such that the short wants to deliver as late as possible.
In regard to (B), please note this is false: the exchange defines a period during which delivery can take place.

I just cannot figure out why is y greater than c in backwardation.
Thanks.

 

[Deepak Chitnis]

Hi @DTu, when the future or forward prices are less than the spot prices then the future or forward curve exhibits backwardation. In the above example forward curve is in backwardation that mean future prices are less than spot prices(similarly spot prices are greater than the future prices), short who is selling the commodity should deliver as late as possible, because spot prices are increasing in the backwardation. c is the cost of carry, and y is the convenience yield, when ever the dividend yield or convenience is greater than the cost of carry or risk free rate the curve exhibits backwardation, that means dividend yield or convenience yield minimizes the value of the asset or commodity. For example if the spot price=$100, risk free rate is=5% and convenience yield=8%, time to maturity=1year, then the future price=S*EXP(risk free rate-convenience yield)*T=$100*EXP(5%-8%)*1=$97.04455. That means future price is less than spot price so the forward or future curve exhibits backwardation, because the convenience yield is greater than the risk free rate. convenience yield is like income earned. Hope that helps!
Thank you

 

[Nicole Seaman]

Hello @DTu

Please be sure to post any questions that you have regarding the practice questions in their original forum post. We include the forum links on the answer page of each practice question set. This helps to keep our forum organized so duplicate questions are not being asked, it helps others who may have the same questions to locate the answers in one place and your question may have already been answered, which saves you the time of reposting. Here is the forum link to this specific question: https://forum.bionicturtle.com/threads/l1-t3-150-definitions-futures-contracts.4411/#post-11368

Thank you,

Nicole

 

[DTu]

Hi @DTu, when the future or forward prices are less than the spot prices then the future or forward curve exhibits backwardation. In the above example forward curve is in backwardation that mean future prices are less than spot prices(similarly spot prices are greater than the future prices), short who is selling the commodity should deliver as late as possible, because spot prices are increasing in the backwardation. c is the cost of carry, and y is the convenience yield, when ever the dividend yield or convenience is greater than the cost of carry or risk free rate the curve exhibits backwardation, that means dividend yield or convenience yield minimizes the value of the asset or commodity. For example if the spot price=$100, risk free rate is=5% and convenience yield=8%, time to maturity=1year, then the future price=S*EXP(risk free rate-convenience yield)*T=$100*EXP(5%-8%)*1=$97.04455. That means future price is less than spot price so the forward or future curve exhibits backwardation, because the convenience yield is greater than the risk free rate. convenience yield is like income earned. Hope that helps!
Thank you

Thank you very much. That's really helpful

 

[DTu]

Hello @DTu

Please be sure to post any questions that you have regarding the practice questions in their original forum post. We include the forum links on the answer page of each practice question set. This helps to keep our forum organized so duplicate questions are not being asked, it helps others who may have the same questions to locate the answers in one place and your question may have already been answered, which saves you the time of reposting. Here is the forum link to this specific question: https://forum.bionicturtle.com/threads/l1-t3-150-definitions-futures-contracts.4411/#post-11368

Thank you,

Nicole

Hi Nicole, I notice that many practice question posts seem to be closed now. I was told that 'You have insufficient privileges to reply here'. So I have no choice but to ask in a new post...

 

[Nicole Seaman]

Hi Nicole, I notice that many practice question posts seem to be closed now. I was told that 'You have insufficient privileges to reply here'. So I have no choice but to ask in a new post...

Hello @DTu,

Thank you for pointing this out. When you see that message, it means that your forum permissions need to be reset or you will be unable to gain access to the entire forum. I reset your forum permissions so you should not have this issue anymore. Please let me know if this happens again, and I will be happy to resolve the issue for you.

Thank you,

Nicole