Stochastic Convenience Yield, Optimal Hedging and the Term Structure of Open Interest and Futures Prices

This paper develops a dynamic, equilibrium model of a futures market to study optimal hedging and the term structure of open interest and futures prices. Investors continuously face spot price risk over time and attempt to hedge this risk using futures. Convenience yield shocks generate basis risk to rolling over near-to-maturity futures. Hence, investors need to simultaneously trade far-from-maturity futures. The model predicts that in markets with substantial and mean reverting convenience yield shocks (e.g. energy futures), open interest is evenly distributed among contracts of different maturities. In markets where these shocks are persistent (e.g. metal futures), open interest is concentrated in near-to-maturity futures. The model generates additional implications regarding how the term structure of futures price volatility and the futures risk premium depend on the nature of convenience yield shocks. JEL No(s): G11, G12, G13