Commodity Convexity

Abstract

We propose a novel measure, namely relative basis, as a more precise proxy for the convenience yield implied by the Theory of Storage. The relative basis, defined as the difference between the traditional near-term basis and a similarly defined longer-term basis, purges out the interference from the storage cost and financing cost. The relative basis dominates the traditional basis in terms of predicting subsequent commodity futures returns. In contrast, it cannot predict the returns of financial futures that have no inventory concern. Additional analysis further confirms that the return predictability of relative basis in commodity markets comes from the Theory of Storage instead of the Theory of Normal Backwardation.