Questions and Answers
What happens to the forward price of a commodity when the present value of storage costs is greater than its convenience yield?
If storage costs are high relative to convenience yield, what is the likely relationship between the forward price and the spot price?
What is implied if the present value of a commodity's storage costs is significantly higher than its convenience yield?
In the context of commodity pricing, what does a higher present value of storage costs imply about forward pricing strategies?
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How does the concept of convenience yield affect the pricing of commodities in relation to storage costs?
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Study Notes
Understanding Forward Price Relationships
- Forward price is the agreed price for future delivery of a commodity, influenced by various market factors including storage costs and convenience yield.
- Convenience yield reflects the benefits of holding a physical commodity versus holding a contract for future delivery, encompassing aspects like availability and usage.
Storage Costs vs. Convenience Yield
- Present value of storage costs represents the cost incurred for holding a commodity, accounting for factors like warehousing and insurance.
- When the present value of storage costs exceeds the convenience yield, it indicates that the costs of physically holding the commodity outweigh the benefits of ownership.
Implications on Forward Price
- Under these conditions, the forward price of the commodity tends to be higher than the spot price compounded at the risk-free rate.
- This relationship occurs because higher holding costs create upward pressure on forward prices, as investors seek compensation for the increased expense of holding the commodity.
Summary of Outcomes
- If storage costs are more significant than convenience yield:
- Forward price is expected to surpass the spot price, adjusted for risk-free interest, reflecting a higher cost of carry.
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Description
Test your understanding of forward prices in relation to present value storage costs and convenience yield. This quiz focuses on the key concepts of forward and spot pricing within commodity markets. Gain insights into how storage costs impact pricing decisions.
