LOS b, (Part 1): Identify and explain the arbitrage situations which arise as a result of the convenience yield of a commodity.

Q1. Jill Mahoney, CFA, trades commodity forward contracts for her clients. The underlying commodities have active lease markets. The prices of some of the forward contracts appear lower than that given by her valuation model based upon the risk-free rate and borrowing rates. One explanation for this is that Mahoney has:

A)   included a convenience yield that is too high.

B)   included storage costs that are too low.

C)   not included the convenience yield.

Q2. Which of the following statements regarding the convenience yield is least accurate?

A)   The convenience yield can be earned by the average investor who does not have a business reason for holding the commodity.

B)   The forward price may appear higher at times, when the convenience yield is not considered.

C)   The commodity borrower is willing to pay the value of the convenience yield less the cost of storage.

Q3. A given commodity has a convenience yield but not all owners of the commodity have a business reason for holding the commodity. If the convenience yield increases, the no-arbitrage range of futures prices would tend to:

A)   be unaffected but still positive.

B)   narrow.

C)   widen

LOS b, (Part 1): Identify and explain the arbitrage situations which arise as a result of the convenience yield of a commodity. fficeffice" />

Q1. Jill Mahoney, CFA, trades commodity forward contracts for her clients. The underlying commodities have active lease markets. The prices of some of the forward contracts appear lower than that given by her valuation model based upon the risk-free rate and borrowing rates. One explanation for this is that Mahoney has:

A)   included a convenience yield that is too high.

B)   included storage costs that are too low.

C)   not included the convenience yield.

Correct answer is C)

The owner of a commodity is able to create a range of no-arbitrage prices as follows: 

Where λ is the storage costs, r is the risk-free rate, and c is the convenience yield. The upper bound depends on storage costs but not on the convenience yield. The lower bound adjusts for the convenience yield and therefore explains why actual forward prices may appear lower at times then when the convenience yield is accounted for in the model.

Q2. Which of the following statements regarding the convenience yield is least accurate?

A)   The convenience yield can be earned by the average investor who does not have a business reason for holding the commodity.

B)   The forward price may appear higher at times, when the convenience yield is not considered.

C)   The commodity borrower is willing to pay the value of the convenience yield less the cost of storage.

Correct answer is A)

The convenience yield cannot be earned by the average investor who does not have a business reason for holding the commodity.

Q3. A given commodity has a convenience yield but not all owners of the commodity have a business reason for holding the commodity. If the convenience yield increases, the no-arbitrage range of futures prices would tend to:

A)   be unaffected but still positive.

B)   narrow.

C)   widen.

Correct answer is C)

The owner of a commodity is able to create a range of no-arbitrage prices as follows:

where:
λ = storage costs
c = convenience yield

The upper bound depends on storage costs but not on the convenience yield. The lower bound adjusts for the convenience yield. If c increases, then the range widens.

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Thx!