Lesson 1 of 8
Commodities have specific features that distinguish them from financial instruments.
Financial markets do not have supply side constraints, i.e., their availability in the markets is not restricted by any factors other than the characteristics of the assets they are comprised of and participants who are associated with them like exchanges, governments, traders, etc. Commodities by their nature are governed by seasonality, production methods, labor costs (to name a few) which determines how they are supplied in the market. On the demand side however both markets tend to be relatively free.
The process by which the commodities are produced and sold often involves storing them as inventories as well and there is a cost associated with this attribute. This maybe due to the seasonality factor, both the supply and demand of this range of products or on the demand side only.
The owner of any commodity can make money by lending and purchasing it back i.e. leasing the commodity in the market.
There are investor specific benefits that result from the ownership of a commodity asset
The lease rate is defined as the rate at which the owner of the commodity lends and buys it back from the investor in the market. During the period when the commodity is leased the ownership does not change hands. The concept is similar to that of the repurchase rate in the bond market. In some cases the market in which such transactions occur is called the leasing market.
When a commodity is being stored it is said to be in the carry markets and it is not generic across each product in the asset class. The cost of storing it should be factored in the forward price. This makes commodities different from financial assets because apart from the financial cost associated with them there is also a cost of storing them which increases the forward price and makes the forward interest rate curve steeper than the normal curve.
The benefits from holding the commodity that result from the physical ownership of the asset are termed as the convenience yield. It is owner specific and may or may not be reflected in the forward price. When the commodity has been loaned out the investor loses out on this yield but saves on the cost of storing the asset.
This property defines range of prices over which the asset can be traded without making an arbitrage profit in the market as it is not necessarily earned back by the investor while engaging in arbitrage.