Explanation

Convenience yield is the non-monetary benefit or premium associated with holding a physical commodity rather than a futures contract. It represents the advantage of having immediate access to the commodity for production or consumption purposes.

Key Points:

1. Convenience yield arises when holding the physical commodity provides benefits such as:

   • Ensuring uninterrupted production processes
   • Meeting unexpected demand
   • Avoiding stockouts
   • Having flexibility in operations

2. Impact on pricing: When convenience yield is high, market participants are willing to pay a premium for holding the physical commodity now rather than in the future. This causes the current spot price to be higher than the market's expectation of the future spot price.

3. Relationship with futures prices: According to the cost-of-carry model: $F = S \times e^{(r + c - y)T}\$ Where:

   • F = Futures price
   • S = Spot price
   • r = Risk-free rate
   • c = Storage costs
   • y = Convenience yield
   • T = Time to maturity

4. When convenience yield (y) is high: It reduces the futures price relative to the spot price, potentially creating a situation called backwardation where spot prices exceed futures prices.

Therefore, convenience yield explains why current spot prices can be higher than expected future spot prices, as market participants value the immediate availability of the physical commodity.