Chapter 5
(Chapter 6 in the
textbook)
Commodity Forwards
and Futures
Points to Note
1. What are the differences between the commodity and the
financial asset? See P.3 to 5.
2. Definitions of backwardation and contango, see P.6 to 10.
3. How do the storage cost and convenience yield determine the
forward price? (see F0,T on p.12 and 13)
4. What does the lease rate mean? See P.15.
5. What is the relationship among the lease rate, storage cost and
convenience yield? See P.16.
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Introduction to Commodity
Forwards
• Differences between commodities and
financial assets include
– Storage costs
The cost of storing a physical item such as corn
or copper. It can be large relative to its value.
– Carry markets
A commodity for which the forward price
compensates a commodity owner for costs of
storage is called a carry market.
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Introduction to Commodity
Forwards (cont’d)
– Convenience yield
The owner of a commodity in a commodity-related
business may receive nonmonetary benefits from
physical possession of the commodity
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Introduction to Commodity
Forwards (cont’d)
– Lease rate
A short-seller of an item may have to
compensate the owner of the item for lending
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Introduction to Commodity
Forwards (cont’d)
• The set of prices for different expiration dates for a
given commodity is called the forward curve (or
the forward strip) for that date
• If on a given date the forward curve is upward
sloping, then the market is in contango. If the
forward curve is downward sloping, the market is in
backwardation
– Note that forward curves can have portions in
backwardation and portions in contango
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Introduction to Commodity
Forwards (cont’d)
• More Commodity Terminologies
– Commodities can be broadly classified as extractive
and renewable.
• Extractive commodities occur naturally in the ground
and are obtained by mining and drilling. Examples
include metals (silver, gold, and copper) and
hydrocarbons, including oil and natural gas.
• Renewable commodities are obtained through
agriculture, and include grains (corn, soybeans),
livestock (cattle, pork bellies) and lumber.
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Introduction to Commodity
Forwards (cont’d)
• More Commodity Terminologies
– Commodities can be further classified as primary and
secondary.
• Primary commodities are unprocessed; corn,
soybeans, oil and gold.
• Secondary commodities have been processed;
gasoline.
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Introduction to Commodity
Forwards (cont’d)
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Introduction to Commodity
Forwards (cont’d)
• From Table 6.1, we have the following observations:
– Contango: Near-term corn and soybeans, and
with gold
– Backwardation: Medium-term corn and soybeans,
and with crude oil
– Uncommon units: A barrel of oil = 42 gallons; A
bushel 2,150 cubic inches; Troy ounce
1.0971 avoirdupois ounce
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The following sections are based on the materials of
“Options, Futures and other Derivatives, by John C.
Hull.”
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Storage Cost
Storage cost can be treated as negative income
(or dividend). So,
F0,T = (S0 + U(0,T))erT
where is U(0,T) the present value of all the
storage cost at 0 over the period [0, T], or
F0,T = S0 e(r+u)T
where u is the storage cost per annum as a
proportion of the spot price.
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Convenience Yield
• For some commodities, we have
F0,T < (S0 + U(0,T))erT or
F0,T < S0 e(r+u)T
• For consumption asset, users of this asset may
feel that ownership of the physical asset provides
benefits that can not be obtained by holding the
futures contract. For example, oil refiner is
unlikely to regard a futures contract on crude oil
to be the same as crude oil held in inventory.
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Convenience Yield (cont’d)
• Convenience yield (y) measures the amount of
benefit that is associated with physically owning
an asset, rather than owning a futures contract
on it. y is defined as
F0,T = (S0 + U(0,T))e(r – y)T
or
F0,T = S0 e(r+u–y)T.
y reflects the market’s expectations concerning
the future availability. Large y → higher chance
that shortages will occur.
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Lease Rate
• For a commodity owner who lends the
commodity, the lease rate is like a dividend.
• With a commodity, the lease rate, l, is the
income earned only if the commodity is loaned. It
is not directly observable, except if there is a
lease market
• l, y and u are related by
l = y - u
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Cost of Carry
• For a commodity, the cost of carry per unit time
per unit price of the underlying (simply say cost
of carry) is given by
r–q+u
where q is the rate of income (convenience
yield) provided by the commodity.
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