Today we will learn in financial futures what is convenience yield?
So today’s video is on the topic of convenience yield in the futures market now if you’re new to derivatives do take a look at my other videos about financial derivatives and finance in general these videos are all based on a book that i wrote a few years ago called trading and pricing financial derivatives and that’s available on amazon if you’re interested i’ll
Put a link in the description below ok so let’s dig into today’s topic which is convenience yield and this is sort of the third video on pricing futures that i have and it makes sense to watch the other two first if if this is a new topic to you this topic convenience yield is something that confuses many finance students so i’ll try to explain it as well as i
Can here so users of a consumption asset and by a consumption asset i mean one that has a use in daily life maybe it’s used in manufacturing or it’s used for a sustenance or it’s needed by businesses or individuals in their daily lives and it gets used up in that process so users of these products might obtain a benefit from actually owning the asset rather than
Owning a futures or a forward contract they need the actual product and not a derivative that gives them the financial equivalents of owning that product the really classic example the example that’s used in every textbook is the idea of heating oil in the winter so and it’s argued that people would happily pay more for physical heating oil in the winter than
They that they can use up right now to heat their houses than they would pay for a future or forward on heating oil that maybe will be delivered in a few months time you know when it’s summertime and they you know they’re they’re not sitting there cold and so any of these kind of consumption assets that are used and that have a real need for them can exhibit this
This pricing thing that we call convenience yield so this benefit the benefit that people get from owning the actual asset rather than the derivative on that asset is known as convenience yield everyone who owns inventory has the choice between consumption today versus investment for the future and a rational individual is going to choose the outcome that’s best
For them the example that i often give to students in my class i came up with this i this class usually in in the winter and as shortly around the christmas month and so the example that i came up with a few years ago was that in the weeks leading up to christmas people will usually pay a good amount of money we’ll say a hundred pounds or more for a christmas
Tree and they know full well that the week after christmas that these things will be littering the the sidewalk of the city so i used to put her in my class a photo of some christmas trees on the sidewalk and say well why did people spend a hundred pounds on these a week ago when you could walk around town and collect them all for free today and so the answer
To that is convenience yield it’s a similar example i guess to heating oil in the winter people don’t have a need to have a tree in their living room in general they just want to have it at the time of year you know they want to have it for christmas either they’re having a party or they have children or what it’s an appropriate seasonal decoration but for some
Reason not a great year-round decoration for your living room and so how do we deal with this idea of convenience yield of something that you’d pay more to have right now than you pay for the sort of financial equivalent of well luckily it’s it’s a fairly simple adjustment to our futures pricing formula and so if you don’t know about our futures pricing formula
Do look at the the earlier video that i did on that but we’re gonna take our regular formula and add in y which is the symbol used for convenience yield so we’re going to adjust our simple formula that i explained earlier to this so f 0 which is the price of a futures contract right now or at time 0 equals s which is the price of the underlying right now once
Again at time 0 times e which is euler’s number to the r + u minus y to the t so r is the interest rate u is storage costs which we also covered in an earlier video and that’s only if applicable and then y is of course convenience yield t is the time to expiration of our futures our forward contract so there you go hopefully that makes sense to you and now you
You know everything you need to know about convenience yield but hold on we haven’t explained something where did we get the number for y we didn’t get that number because no one can tell us that we can’t actually know how much more someone will hey at a given time to receive the underlying right now rather than than waiting for the future so it’s important to
Understand that why is actually backed out from market prices you can never be given a number for convenience yield in real life and be told that that’s that’s the additional percentage people will pay instead what you do is you reverse it out from market prices so that you can understand what convenience yield the market is implying for that asset right now at
This given point in time so it’s a little bit different it’s it’s the reason i made a separate video for convenience yield rather than our other pricing formulas is the convenience yield is quite different simply because it’s backed out of market prices rather than a number that you know that you can put in and and on price a future or forward so hopefully now
That makes sense to you you will of course need a financial calculator to calculate all of these formulas and i’ve put links in the description below to the two that are used on the cfa exams i’ve mentioned this in earlier videos that if you don’t have a financial calculator it possibly make sense to get one of those ones just in case you do the cfa exam obviously
If you’ve already got a financial calculator you can use that one these the two calculators that i recommend that both do the exact same thing but they work a little bit differently so take a look at the reviews before you you buy the one that appeals most to you hopefully you found this video helpful if so please like please subscribe please share with your
Friends and equally do comment below if there’s something you’d like me to explain as there’s a financial topic you’d like me to go over when you have a great day talk to you later bye
Transcribed from video
Convenience Yield By Patrick Boyle
