3-2 - Raw Material Convenience Yields and Business Cycle...

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Raw Material Convenience Yields and Business Cycle Chang-Wen Duan * William T. Lin Department of Banking and Finance, Tamkang University, Taiwan. Abstract This paper extends the methodology of Milonas and Thomadakis (1997) to estimate raw material convenience yields with futures prices form 1996 to 2005. We define the business cycle of a seasonal commodity with demand/supply shocks and find that the convenience yields for crude oil and agricultural commodity exhibits seasonal behavior. The convenience yield for crude oil is the highest in the winter, while that for agricultural commodities are the highest in the initial stage of harvest period. The empirical result show that WTI crude oil is more sensitive to high winter demand and that Brent crude oil is more sensitive to shortages in winter supply. The theory of storage points out that the marginal convenience yield on inventory falls at a decreasing rate as inventory increase which could be verified through those products affected by seasonality, but could not be observed by products affected by demand/supply. Convenience yields are negatively related to interest rates. The negative relationship implies that the increase in the carry cost of commodity, namely the interest rate, would cause the yield of holding spot to decline. We also show that convenience yields may explain price spread between WTI crude oil and Brent crude oil , and the ratio between soybean and corn as well. Our estimated convenience yields are consistent with Fama and French (1988) in that commodity prices are more volatile than futures prices at low inventory level, verifying the Samuelson (1965) hypothesis that future prices are fewer variables than spot prices at lower inventory levels. * Please address all correspondence to Chang-Wen Duan, Department of Banking and Finance, Tamkang University, 151 Ying-Chuan Road, Tamsui, Taipei County 25137, Taiwan, R.O.C. Email: 107800@mail.tku.edu.tw, Tel: +886-939-117211; Fax: +886-2-2621-4755.
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Keyword: business cycle, convenience yield, crop year, demand/supply shock, theory of storage, two-period model. JEL Classification: E12, E32, G13, Q00, Q18, Q40. 2
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1. Introduction This paper applied the call option model to estimate convenience yields for four storable commodities. The empirical results derived from the analysis of price and stock data covering the period 1996 to 2005 1 . Our estimated convenience yields extend the Fisher (1978) model, which utilizes a non-traded asset as strike price. We instead set the price of a traded asset to be the strike price of the option in our model. In addition, our analyses differ from the Milonas and Thomadakis (1997) model in that we not only fit the price of a traded asset, such as commodity futures prices, as the strike price but also add in storage cost when estimating the convenience yield. Our purpose is to examine convenience yields while taking into account inventory level, volatility and interest rates, evaluating the consistency between our empirical study and the theory of storage.
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This note was uploaded on 07/26/2011 for the course ECON 101 taught by Professor Markspenser during the Spring '11 term at Webster FL.

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3-2 - Raw Material Convenience Yields and Business Cycle...

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