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FRM Part I · FRM Exam Part I · Commodity Forwards and Futures

A copper market is in steep backwardation. Which explanation is most consistent with this shape under the cost-of-carry model with convenience yield?

Backwardation arises when the convenience yield exceeds the interest rate plus storage cost, since then the net cost of carry is negative and futures prices fall below spot. High convenience yield reflects scarce inventories and a premium on holding the physical commodity.

  1. AThe convenience yield exceeds the sum of the interest rate and storage costCorrect
  2. BStorage costs exceed the convenience yield and the interest rate combined
  3. CThe risk-free rate is zero and storage costs are zero
  4. DInventories are abundant, so holding physical copper has no benefit

Explanation

F = S*exp((r+u-y)T). Futures are below spot when y > r+u. Abundant inventories imply low convenience yield, which gives contango, so the last option is wrong.

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