CFA Level I · CFA Level I Exam · Arbitrage, Replication, and the Cost of Carry in Pricing Derivatives
A commodity has storage costs and a convenience yield. If the convenience yield rises while the risk-free rate and storage costs stay constant, the no-arbitrage forward price is most likely to:
The forward price falls. Convenience yield is a benefit of holding the physical asset, and it offsets financing and storage costs in the cost of carry. A larger benefit lowers net carrying costs, so the no-arbitrage forward price is lower.
- Arise, because storage becomes more valuable
- Bfall, because holding the physical asset provides greater benefitsCorrect
- Cstay the same, because convenience yield is not observable
Explanation
Benefits of holding the underlying, such as convenience yield, reduce the cost of carry. Forward price = S0 x e^((r + storage - convenience)T), so a higher convenience yield lowers the forward price. Option A reverses the sign of the benefit.
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