Backwardation can happen in markets where

Backwardation can happen in markets where
A . convenience yield is less than the total interest and carrying costs
B . convenience yields are greater than the total interest, storage and other carrying costs
C . convenience yields are positive
D . convenience yields are zero

View Answer

Answer: B

Explanation:

Convenience yield is the benefit from having access to the commodity – and if the convenience yield is very high, for example in a market where manufacturers must never run out of a particular raw material, then these can switch the total cost of carry (which include interest and storage costs, less convenience yields) to being negative. This causes forward prices to become lower than spot prices, a phenomenon known as backwardation. Therefore Choice ‘b’ is the correct answer. If convenience yields are less than other carrying costs, then backwardation will not happen. The sign of convenience yields does not matter, what matters is their relative magnitude when compared to the other costs of carry.

To understand this in an intuitive way, consider that forward prices are nothing but spot prices, plus interest, plus storage costs, less convenience yields. If interest and storage costs are less than the convenience yield, the market will be backwarded.