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Something I'm having difficulty wrapping my head around is the argument that commodity futures can be in backwardation due to a large convenience yield, for example "to keep a production process running". When I think of the cost of carry, I think of it intuitively as what costs the party long the asset incurs by holding the asset to expiry. The costlier it is for the holder of the asset during this time to expiry, the higher the forward price.

I'm having trouble seeing how the person that is "holding onto" the asset until expiry can just decide to consume the commodity if needed and that provides value. For example, if I'm short forward and long the commodity in a cash-and-carry arb, I can consume the commodity, but I have to buy it back later in order to close out my short position. So I don't see any value of being able to consume the commodity given that I'll have to buy it back then to close out my cash and carry.

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You mention Cost of Carry and Convenience Yield as if they are similar. Actually Cost of Carry and Convenience Yield work in opposite directions. CoC makes the holding of a physical commodity less attractive than it would otherwise be. CY makes holding the commodity more attractive despite other factors that are not favorable. In a situation where it does not make sense to hold the commodity and it would even be a good idea to short it, but people do not do so, it must be [according to economic theory] because of some CY that people receive.

Suppose copper is available for future delivery in 3 months at a price much lower than today's spot price. Who are the idiots who buy spot copper instead of buying the future? They are not idiots, they are people who own a copper tube manufacturing factory and need copper to use in their plant during the next 3 months. For them spot copper has a "convenience yield", for them futures are not a substitute for the spot commodity (they can't tell the workers: "put some futures in the machine today, we have run out of copper and I only have futures."). Because of the "signal" from the Futures Markets these people will operate "from hand to mouth" buying as little copper as possible to cover immediate needs, but they still need to buy copper.

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  • $\begingroup$ That makes sense, thank you. My question is more from a pure spot future parity perspective, ie if the forward price is equal to spot + cost of carry (with CY reducing this net cost). If not, there should be risk free arb. But I don’t understand the cash and carry arb in this scenario where the asset is a consumable commodity. In other words, assume a forward with a convenience yield is overpriced. If one enters into the short forward position and is long the underlying asset, they can’t take advantage of the benefit of consumption because they need to deliver to close the arb. $\endgroup$
    – rb612
    Commented Feb 3 at 16:17
  • $\begingroup$ Contrast this with a dividend for a forward on an equity product. The dividend reduces the forward price just like a convenience yield, but it makes sense in the context of cash and carry: the one doing this arb actually earns the dividend while holding the asset to close out the arb, so there must be a reduction in forward price. But CY doesn’t seem to be an actual benefit for the arbitrageur. The arbitrageur must hold onto the asset and not consume it, for if they do, they’d need to buy it back in the spot market, so how is it a benefit? $\endgroup$
    – rb612
    Commented Feb 3 at 16:20

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