As described earlier, that some assets have benefits and costs associated with them. The benefits and costs occur during the contract period. The benefits can be classified into two categories: monetary benefits and non-monetary benefits. Monetary benefits are the interim cash flows like dividends and coupons. Non-monetary benefits are hard to measure and are opaque in nature. They are also referred to as convenience yield. The assets with extremely short supply or the assets that are hard to sell short especially commodities have high convenience yield.
The cost of holding assets primarily includes opportunity costs, storage costs, and insurance costs. The greater are the costs, the higher the price of the forward contract. The greater are the benefits, the lower the price of the forward contract.
The net of costs and benefits is called as the cost of carry. If the cost of carry is positive i.e. total costs are greater than total benefits, then the forward price will be higher than the spot price. If the cost of carry is negative i.e. the asset has net benefits for holding it or the total benefits exceed the total cost, then the forward price will be lower than the spot price.
Check your concepts:
(58.9) Which of the following factors is least likely to have a positive impact on the convenience yield?
(a) Less demand for the asset
(b) Short supply of the asset
(c) Difficulty in short selling the asset
Solutions:
(58.9) Correct Answer is A: The convenience yield is higher when the asset is in short supply or is difficult to sell short. Less demand for the asset has no positive impact on the convenience yield.
Previous LOS: Determination of value and price of a forward contract
Next LOS: Forward rate agreement and its uses
