© 1998, Futures Industry Institute. All Rights Reserved.

IN THIS SECTION:
Introduction | Futures Contracts | Options Contracts | Prerequisites For Futures and Options Markets |
Contract Innovations | A Comparison Of Futures, Equities, Forwards and Over-the-Counter Derivatives

Introduction

Modern futures markets have been traced to the trading of rice futures in
eighteenth century Osaka, Japan. In the United States, futures trading
began in the mid-nineteenth century with corn contracts in Chicago and
cotton in New York. Today, futures and options trading is a leading financial
activity throughout the world, with contracts traded on a wide variety of
commodities, financial instruments and indexes.

Exchange-traded futures and options provide several important economic

benefits, including the ability to shift or otherwise manage the price risk of
cash market or tangible positions. As open markets where large numbers of
 potential buyers and sellers compete for best prices, futures markets
effectively discover and establish competitive prices. In part because these
markets provide the opportunity for leveraged investments, they attract
large pools of risk capital. As a result, futures markets are among the most
liquid of all global financial markets, providing low transaction costs and
ease of entry and exit. This, in turn, fosters their use by an array of
business enterprises and investors to manage their price risks. And the
savings resulting from effective risk management can be passed on to the
final consumers of the commodities, currencies and financial instruments
that underlie the futures and options contracts.

Figure 1
Annual Futures & Options Contract Volume
[Courtesy of FIA]

Today's futures industry functions with a number of time-tested institutional

arrangements, including clearinghouse guarantees and exchange self-
regulation. Futures and options markets also reflect a tradition of innovation
and growth, with new products, new exchanges and record trading volumes
appearing each year. And while the U.S. markets have continued their
pattern of steady expansion, recent increases in trading activity have been
most pronounced outside the United States in the newer markets of Europe,
Asia, Australia and Latin America, as evidenced in Figure 1.

Next...

© 1998, Futures Industry Institute. All Rights Reserved.

Futures Contracts

A futures contract is a standardized agreement between two parties that a) commits one to sell and
the other to buy a stipulated quantity and grade of a commodity, currency, security, index or other
specified item at a set price on or before a given date in the future; b) requires the daily settlement
of all gains and losses as long as the contract remains open; and c) for contracts remaining open
until trading terminates, provides either for delivery or a final cash payment (cash settlement).

These contracts have several key features:

 The buyer of a futures contract, the "long," agrees to receive delivery;

 The seller of a futures contract, the "short," agrees to make delivery;
 The contracts are traded on exchanges either by open outcry in specified trading areas
(called pits or rings) or electronically via a computerized network;
 Futures contracts are marked to market each day at their end-of-day settlement prices, and
the resulting daily gains and losses are passed through to the gaining or losing accounts;
 Futures contracts can be terminated by an offsetting transaction (i.e., an equal and
opposite transaction to the one that opened the position) executed at any time prior to the
contract's expiration. The vast majority of futures contracts are terminated by offset or a
final cash payment rather than by delivery; and
 The same or similar futures contracts can be traded on more than one exchange in the
United States or elsewhere, although normally one contract tends to dominate its
competitors on other exchanges in terms of trading activity and liquidity.

A standardized futures contract has a specific:

 Underlying instrument--the commodity, currency, financial instrument or index upon
which the contract is based;
 Size--the amount of the underlying item covered by the contract;
 Delivery cycle--the specified months for which contracts can be traded;
 Expiration date--the date by which a particular futures trading month ceases to exist and
therefore all obligations under it terminate;
 Grade or quality specification and delivery location--a detailed description of the
"par" commodity, security or other item that is being traded and, as permitted by the
contract, a specification of items of higher or lower quality or of alternate delivery locations
available at a premium or discount; and
 Settlement mechanism--the terms of the physical delivery of the underlying item or of a
terminal cash payment. The only non-standard item of a futures contract is the price of an
underlying unit, which is determined in the trading arena.

The mechanics of futures trading are straightforward: both buyers and sellers deposit
funds--traditionally called margin but more correctly characterized as a performance bond
or good faith deposit--with a brokerage firm. This amount is typically a small percentage--
less than 10 percent--of the total value of the item underlying the contract.

Figure 2: Figure 3:
Payoff Diagram of a Long Futures Position Payoff Diagram of a Short Futures Position
As indicated in Figure 2, if you buy (go long) a futures contract and the price goes up, you profit
by the amount of the price increase times the contract size; if you buy and the price goes down,
you lose an amount equal to the price decrease times the contract size. Figure 3 reflects the profit
and loss potential of a short futures position. If you sell (go short) a futures contract and the price
goes down, you profit by the amount of the price decrease times the contract size; if you sell and
the price goes up, you lose an amount equal to the price increase times the contract size. These
profits and losses are paid daily via the futures margining system, as illustrated later in this
program

Options Contracts

An option is the right, but not the obligation, to buy or sell a

specified number of underlying futures contracts or a specified
amount of a commodity, currency, index or financial instrument
at an agreed upon price on or before a given future date.
Options on futures are traded on the same exchanges that
trade the underlying futures contracts and are standardized
with respect to the quantity of the underlying futures contracts
(by custom, one futures contract), expiration date, and
exercise or strike price (the price at which the underlying
futures contract can be bought or sold).

In the United States, standardized options that are exercisable directly into securities and securities
indexes are classified as securities subject to regulation by the Securities and Exchange Commission
(SEC); these contracts are traded on U.S. securities exchanges. In contrast, futures and options on
futures (including options on many stock index futures) are regulated by the Commodity Futures
Trading Commission (CFTC) and traded on futures exchanges. The situation differs outside of the
United States where, in many countries, there is a less distinct regulatory separation of the futures
and securities industries and where, in many cases, financial futures are traded on stock
exchanges.

There are two types of options - call options and put options. A call option on a futures contract
gives the buyer the right, but not the obligation, to purchase the underlying contract at a specified
price (the strike or exercise price) during the life of the option. A futures put option gives the buyer
the right, but not the obligation, to sell the underlying contract at the strike or exercise price before
the option expires. The cost of obtaining this right to buy or sell is known as the option's
"premium." This is the price that is bid and offered in the exchange pit or via the exchange's
computerized trading system. As with futures, exchange-traded options positions can be closed out
by offset--execution of a trade of equal size on the other side of the market from the transaction
that originated the position.

The major difference between futures and options arises from the different obligations of an
option's buyer and seller. A futures contract obligates both buyer and seller to perform the contract,
either by an offsetting transaction or by delivery, and both parties to a futures contract derive a
profit or loss equal to the difference between the price when the contract was initiated and when it
was terminated. In contrast, an option buyer is not obliged to fulfill the option contract. The option
buyer's loss is limited to the premium paid, but in order for the buyer to make a profit, the price
must increase above (call option) or decrease below (put option) the option's strike price by the
amount of the premium paid. In turn, the option seller (writer or grantor), in exchange for the
premium received, must fulfill the option contract if the buyer so chooses. This situation--the
option's exercise--takes place if the option has value (is "in the money") before it expires.

Prerequisites for Futures and Options Markets

Wherever there is price volatility, there is a potential need for futures and options contracts.
Originally developed for food and fiber crops, futures markets now also encompass livestock,
precious and industrial metals, petroleum and other energy products, fixed-income securities,
interbank deposits, currencies and stock indexes, as well as other intangibles such as catastrophic
insurance. Whatever the item underlying the futures or options contract, every market needs
certain ingredients to flourish. These include:

 Risk-shifting potential--the contract must provide the ability for those with price risk in
the underlying item to shift that risk to a market participant willing to accept it.
 Price volatility--the price of the underlying item must change enough to warrant the
need for shifting price risk.
 Cash market competition--the underlying cash (or physicals) market must be broad
enough to allow for healthy competition, which creates a need to manage price risk and
decreases the likelihood of market corners, squeezes or manipulation.
 Trading liquidity--active trading is needed so that sizable orders can be executed rapidly
and inexpensively.
 Standardized underlying entity--the commodity, security, index or other item
underlying the futures contract must be standardized and/or capable of being graded so
that it is clear what is being bought and sold.

Contract Innovations

The futures industry has a long history of product innovation.

Corn, wheat, and cotton trading dates from the post-Civil War
period in the United States. Metals trading began in the 1920s,
while refined agricultural products--soybean meal and oil--
became available in the early 1950s. A new wave of innovation
began in the 1960s when futures on a perishable commodity--
livestock--were first introduced.

In 1972, following the demise of the Bretton Woods system of

fixed exchange rates, the financial futures era began with the
introduction of futures contracts on foreign currencies. With the legalization of private ownership of
gold by U.S. citizens at the end of 1974, gold futures commenced trading. As interest rates became
more volatile, futures exchanges introduced interest rate futures, beginning in 1975 with the GNMA
contract based on a pool of mortgages. The following year three-month Treasury-bill futures were
introduced, and in 1977 the very popular Treasury-bond futures contract debuted. Energy futures
trading in the United States dates from the 1978 inauguration of heating oil futures. Following the
weakening of OPEC's control over the global oil market, other successful petroleum-based futures,
most notably crude oil and gasoline contracts, were introduced.
All these relatively recent futures contracts adopted and adapted the delivery mechanism designed
for grain and cotton trading developed in the mid-1800s. That delivery mechanism assured price
convergence between the expiring futures contract and the underlying cash market, thereby
validating futures contracts as hedging instruments. In 1981, Eurodollar futures became the first
futures contract that did not require delivery. Instead, the contract called for settlement in cash, in
effect a payment on the last trading day of the difference between a reputable, independent and
widely accepted cash price and the futures price. The cash-settlement innovation safeguarded the
futures contract's usefulness to hedgers and opened the way for new types of contracts on which a
delivery option would be impossible or prohibitively expensive; most notable among these are stock
index futures, which began trading in 1982. That same year options on futures were reintroduced
after a 50-year ban in the United States.

The mid- to late-1980s also were a period of phenomenal international growth of futures and
options markets, as numerous new exchanges opened throughout the world. While these
exchanges offer a range of contracts, their most successful products fall into three broad categories
modeled on the innovative contracts introduced in Chicago from 1977 to 1982--futures and options
on government bonds, short-term interbank interest rates and stock indexes. The U.S. prototypes
of these successful global contracts are the U.S. Treasury bond, Eurodollar, and S&P 500 stock
index futures and options.

A Comparison of Futures, Equities, Forwards

and Over-the-Counter Derivatives

Futures have a number of characteristics in common with equities, forward contracts and over-the-
counter (OTC) derivatives, as well as a number of dissimilarities. A comparison of these financial
instruments is useful to understand the purposes and functions of futures contracts.

Futures and Equities

Important differences between futures and equities include:

 Purpose--futures markets exist to facilitate risk shifting and price discovery; the principal
purpose of equities markets is to foster capital formation.
 Short positions--in futures trading there is a short for every long; in equities markets,
short positions are normally a minor factor. In addition, establishing a short position in a
futures market is no more difficult than establishing a long position. In contrast, a short
position in equities requires owning or borrowing the securities and payment of dividends.
 Margin--the customer funds deposited to carry a futures position are a performance bond
or good faith money, securing the promise to fulfill the contract's obligations. Typically,
futures positions are marked to market on a daily basis, and no interest is charged to
maintain a futures position. In margined stock purchases, the margin acts as a down
payment, and the balance of the purchase price is borrowed, with interest charged. There
is no daily marking to market in the equities markets, but if prices change by a significant
amount a maintenance margin call is made.
 Maturity--the life of a futures contract is limited to its specified expiration date; most
equities are issued without a termination date.
 Price and position limits--a price limit on a futures contract establishes the maximum
range of trading prices during a given day. A futures position limit establishes the maximum
exposure a market participant may assume in a particular market. Many futures markets
 have price and/or position limits. Equities typically do not have limits on price movements
or the size of positions.
 Supply--while the outstanding number of equities is fixed at a given moment, there is no
theoretical limit on the number of futures or futures options that may exist at a particular
time in a specific market.
 Ownership record--unlike equities, where a customer can ask a broker for a certificate
that evidences ownership, there are no comparable certificates for futures or futures
options. A customer's written record of a futures position is the trade confirmation received
from the brokerage house through which the trade was made.
 Market-making system--open-outcry futures markets typically operate with a multiple
market-maker system, involving floor traders and floor brokers competing on equal footing
in an auction-style, open-outcry market. Equities markets typically operate with a specialist
system, where the designated specialist has specified privileges and responsibilities with
respect to a given stock, although non-specialist brokers also may compete for trades.

Futures and Forward Contracts

A forward contract can be considered a customized futures contract. A forward is an agreement

between two parties to buy or sell a commodity or asset at a specific future time for an agreed
upon price. Typically, the contract is between a producer and a merchant; two financial institutions;
or a financial institution and a corporate client. Historically, forward contracts developed as
customized instruments involving delivery of an underlying commodity or financial instrument.

Important distinctions between forward and futures contracts include:

 Contract guarantee--the performance of futures and futures options contracts is

guaranteed by the clearinghouse of the exchange on which the contracts are executed.
Because no such clearinghouse exists for forward contracts, participants must pay
particular attention to counterparty creditworthiness.
 Cash flows--exchange-traded contracts involve daily payments of profits and losses via a
mark-to-market margining system, while forward contracts generally do not involve daily or
other periodic payments of accumulated gains or losses. As a result, large paper losses and
gains may accumulate with forward contracts and increase the likelihood and cost of a
default. Alternatively, depending upon the creditworthiness of the counterparties and the
magnitude of the exposure, parties to forward contracts may be required to post collateral
and/or make periodic payments against accumulated losses.
 Contract terms--futures contracts are standardized; forward contracts are created on a
customized basis, with terms such as the grade of the underlying commodity or asset,
delivery location and date, credit arrangements and default provisions negotiated between
and tailored to the needs of the two parties.
 Liquidity--in the absence of standardized contracts and a large number of buyers and
sellers, forward markets often lack the low transaction costs and ease of entry and exit
found on liquid exchange markets.

Futures and Over-the-Counter Derivatives

Over-the-counter derivatives encompass tailored financial instruments, such as swaps, swaptions,

caps and collars, that are traded in the offices of the world's leading financial institutions. OTC
derivatives are similar to forward contracts that have been used by commercial enterprises for over
a century; each of the previously mentioned distinctions between futures and forwards discussed
above also applies to a comparison of futures and OTC derivatives. As with forwards, the growth of
OTC derivatives trading has been fostered by the existence of liquid futures and options exchange
markets in which the risks of the customized OTC instruments can be transferred to a broader
marketplace.

IN THIS SECTION:
Regulators | Exchanges | Clearinghouses and Margins | Futures Commission Merchants | Introducing
Brokers | Commodity Pools | Commodity Trading Advisors

Regulators

The U.S. futures industry has three levels of regulation:

1. the Commodity Futures Trading Commission, an

independent federal regulatory agency;
2. the National Futures Association, an industry-wide self-
regulatory organization, and
3. the futures exchanges that have regulatory obligations for their
members.

Next...

© 1998, Futures Industry Institute. All Rights Reserved.

Exchanges

Futures and options exchanges are associations of members organized

to provide competitive markets and the facilities and staffs to support
such markets. The first U.S. futures exchange was the Chicago Board of
Trade, organized in the mid-nineteenth century. Fifty years later, nearly
all major U.S. exchanges that operate today had been formed. During
the last decade the number of futures exchanges throughout the world
has rapidly increased to more than 70.

In the United States, exchange membership is available only to individuals, some of whom hold a
membership for their firm. Members of an exchange may exercise their trading privileges as
independent market-makers (so-called floor traders or locals) trading for their own accounts or as
floor brokers executing customer orders. Exchange members who trade both for customers and for
themselves are called dual traders.
Today, the greatest amount of futures and futures options trading is conducted by open outcry in
exchange pits or trading rings. However, computerized futures and options markets have grown
significantly during the last decade, both as the sole mode of trading and as an after-hours
supplement to open-outcry trading during regular business hours.

In open-outcry trading, exchange members stand in pits making bids and offers, by voice and with
hand signals, to the rest of the traders in the pit. Customer orders coming into the futures pit are
delivered to floor brokers or dual traders who execute them according to the order's instructions.
For example, a "market" order tells the broker to execute the order immediately at the prevailing
price in the pit; a "limit" order specifies the price (or better) at which the order can be filled; and a
"stop" order tells the broker to execute an order at the market price if a certain price is reached.
Other types of orders specify the time of the trade (e.g., at the market's open or close) or allow a
broker discretion in the execution. Orders also can indicate the period for which they are valid, e.g.,
a day, a week or until canceled.

The Life of a Futures Contract chart traces a customer order from its initiation through the
clearing process and indicates how futures volume and open interest are created, extinguished and
tallied.

Clearinghouses and Margins

All futures and options exchanges have clearinghouses that play a central role in these markets.
Most notably, a futures clearinghouse facilitates trade among strangers by eliminating counterparty
risk and guaranteeing the integrity of the contracts. In the United States, historically, each futures
exchange has had its own clearinghouse--either formed as a separate entity or as a part of the
exchange. Recently, a number of U.S. futures exchanges have begun exploring modes of common
clearing; in other countries, such as the United Kingdom, and for U.S. securities options, a single
clearinghouse serves several exchanges.

Only clearinghouse members can submit trades to the clearinghouse, and while every member of a
clearinghouse must also be a member of the related exchange, not all exchange members are
members of the clearinghouse. Clearinghouse membership involves financial requirements and
responsibilities over and above those of exchange membership, including the maintenance of a
guaranty deposit at the clearinghouse. This deposit serves as a reserve fund that can be used, if
necessary, to meet the financial obligations of a defaulting clearing member.

It is the clearinghouse's responsibility to collect original margin from its members for the futures
and options contracts traded on the exchange. The clearinghouse's original margin, which is the
minimum amount clearing members normally collect from their customers, reflects historical price
volatility and generally is set at a level sufficient to protect the clearinghouse against one day's
maximum (or historically very large) price movement in the particular futures or options contract.

As part of the daily marking to market of futures and options, clearing members each day pay to or
receive from the clearinghouse funds known as variation margin. In volatile markets variation
margin may be collected intraday, with clearing members sometimes required to deposit funds
within one hour of the margin call.

In contrast to clearinghouse margins, minimum customer margins in futures and options markets
are set by the exchanges on which the contracts trade. For most contracts, there is a difference
between the amount of margin exchanges require to be deposited when a trade is initiated (initial
margin) and the minimum amount of margin the customer must maintain in his or her account at
all times for each open position (maintenance margin). For a few contracts and for many
commercial accounts, the initial and maintenance margin levels may be the same.

The process of marking futures positions to market each day ensures that accounts are kept
current. If there is profit, this can be paid to the customer. If there is a loss, the customer pays the
full amount. If the loss is greater than the margin funds on deposit, the customer is required to pay
the difference. The Margining Example provides an example of how customer margins work in
practice.

Futures Commission Merchants

A futures brokerage firm, known as a futures commission merchant (FCM),

is the intermediary between public customers, including hedgers and
institutional investors, and the exchanges; it is the only entity outside the
futures clearinghouse that can hold customer funds. A brokerage firm
provides the facilities to execute customer orders on the exchange and
maintains records of each customer's positions, margin deposits, money
balances and completed transactions. In return for providing these
services, a brokerage firm collects commissions.

In the United States, a futures brokerage firm must meet a number of

regulatory requirements, including the maintenance of a minimum level of
net capital. A futures brokerage firm also must be a member of the National Futures Association
(NFA), an industry-wide self-regulatory organization. An FCM may be a full-service or a discount
firm. Some FCMs are part of national or regional brokerage companies that also offer securities and
other financial services, while other FCMs offer only futures and/or futures options to their
customers. In addition, some FCMs have as a parent or are related to a commercial bank,
agribusiness company or other commercial enterprise.

Introducing Brokers

An introducing broker (IB) is an individual or firm that has established a relationship with one or
more brokerage firms. Similar to an FCM, an IB is responsible for maintaining customer
relationships and servicing customer accounts, and its sales force receives commissions. However,
an IB cannot accept funds from its customers, and, as a result, all customers of IBs must open and
maintain accounts with an FCM.

There are two types of introducing brokerage firms--independent and guaranteed. IBs that have
sufficient capital to meet regulatory requirements may choose to introduce their clients through a
number of different FCMs. Such IBs are known as independent or non-guaranteed IBs. A
guaranteed IB has a legal and regulatory relationship with the guarantor FCM through which the IB
introduces its customers.

Commodity Pools

Many large institutions as well as numerous individual investors

throughout the world now include managed futures positions in their
portfolios. These positions can be in the form of commodity pools or
individually managed accounts at an FCM. A private commodity pool or
public commodity fund operates much like a stock or bond mutual fund
in that investors with limited resources or time can purchase diversified investments that are
professionally managed. As with mutual funds, a number of commodity pools are sponsored by
major brokerage firms. However, in many cases commodity pools provide significantly more
leverage than stock mutual funds. Commodity pools also provide limited liability to their investors,
since the risk of loss is no greater than the amount of capital invested. This contrasts with an
individual futures account, including individually managed accounts, in which the investor can
receive margin calls and lose more money than was initially deposited.

Commodity Trading Advisors

A commodity trading advisor (CTA) trades for others and/or makes

trading recommendations to others. CTAs are responsible for trading
individually managed accounts and are hired to trade on behalf of
commodity pools and funds. CTAs typically receive two types of
compensation: a management fee, which is levied whether or not the
client makes money, and an incentive fee, charged as a percentage of
net new trading profits in the client's account

How Futures Contracts are

Created and Extinguished (Offset)
1. Creation of a Futures Contract:
Neither Buyer Nor Seller Has Any Current Futures Positions.
 How Futures Contracts are
Created and Extinguished (Offset)
2. Extinguishing (Offset) of a Futres Contract:
Buyer and Seller Have Current Opposite Futures Positions
 *Assume Buyer's and Seller's FCMs are members of the clearinghouse.

How Futures Contracts are

Created and Extinguished (Offset)
3. Creation and Extinguishing (Offset) of a Futures Contract:
One Trader Has A Current Futures Position and One Trader Does Not.
*Assume Buyer's and Seller's FCMs are members of the clearinghouse.

IN THIS SECTION:
Hedging | The Cash Futures Basis | Spreading | Intramarket Spreads | Intermarket Spreads

Hedging

Historically, futures market participants have been divided into two broad
categories: hedgers, who seek to reduce risks associated with dealing in the
underlying commodity or security, and speculators (including professional
 floor traders), who seek to profit from price changes. More recently, a new
category of participant has emerged--the portfolio manager who uses
futures and options as essential elements of portfolio management. For
speculators, the attraction of futures markets includes their leverage, the
diversification they add to a portfolio, the ease of assuming short as well as
long positions, and the low cost of market entry and exit. Speculators and
market-makers assume the risk transferred by hedgers and provide the
liquidity that assures low transaction costs and reliable price discovery in
futures markets.

Hedging is central to futures and options markets, and a familiarity with

hedging practices is necessary to understand how these markets work. In
simplest terms, hedgers:

 Identify their price risk,

 Decide how much to hedge, and
 Decide where and how to hedge.

In futures markets hedging involves taking a futures position opposite to

that of a cash market position. That is, a corn farmer would sell corn futures
against his crop; an importer of Japanese cars would buy yen futures
against her yen liability; a precious metals merchant would purchase gold
futures against a fixed-price gold sales contract; and a pension fund
manager would sell stock index futures against the fund's portfolio of
equities in anticipation of a market decline.

Examples of the types of risk - management activities that rely on the use of
futures include:

 Stabilizing cash flows;

 Setting purchase or sale prices of commodities and securities;
 Diversifying holdings;
 More closely matching balance sheet assets and liabilities;
 Reducing transaction costs;
 Decreasing costs of storage; and
 Minimizing the capital needed to carry inventories.

Next...

© 1998, Futures Industry Institute. All Rights Reserved.

The cash-futures basis

The difference between a commodity's or security's

cash and futures prices is known as the "cash-
futures basis," as illustrated in Figure 4. While
futures trading can eliminate price level risk, it
cannot eliminate the risk that the basis will change
unfavorably and unpredictably during the lifetime of

Figure 4:
Cash-futures Basis
the hedge. The cash-futures basis is subject to many influences, including seasonal factors,
weather conditions, temporary gluts or scarcities of commodities, and the availability of transport
facilities. Other factors affecting the relationship between cash and futures prices are costs related
to carrying commodities and securities, such as interest rates and warehouse fees. In certain
financial markets, basis reflects the difference between long-term and short-term interest rates.

Basis risk is particularly prevalent in "cross hedging" one commodity with another one. For
example, if the commodity to be hedged does not have an exact match in the futures market, the
closest commodity may have to be substituted--e.g., heating oil futures to hedge jet fuel needs or
Deutschemarks to hedge Dutch guilder payments. Prices of the two types of fuel or two currencies
may have moved closely for significant periods of time, but there is no guarantee that past price
relationships will continue into the future.

Spreading

A spread position is the simultaneous purchase and sale of two

related futures or options positions. Spread positions are
undertaken when the prices of two futures or options contracts
are considered out-of-line with each other. In many ways
futures and options spreads are analogous to arbitrage or quasi-
arbitrage positions. Futures spreads can be divided into two
broad categories: intramarket spreads and intermarket spreads.

Intramarket Spreads

An intramarket spread, also called a time spread, comprises a long position in one contract
month against a short position in another contract month in the same futures contract on the
same exchange. An example would be long March world sugar futures vs. short July sugar
futures on the Coffee, Sugar & Cocoa Exchange or short October cotton futures vs. long
December cotton futures on the New York Cotton Exchange.

Figure 5: Figure 6:
Carrying Charge or Contango Market Inverted Market or Backwardation

The spread, or difference, between the prices of various futures delivery months reflects supply,
demand and carrying costs. Because carrying costs generally increase over time, in many futures
markets the price of each succeeding delivery month is higher than that of the preceding delivery
month. This is called a carrying-charge, or contango, market, as illustrated in Figure 5.

In contrast, in some futures markets the highest price is for the nearby or spot month, and each
successive delivery month is priced lower than the preceding month, as depicted in Figure 6. This
is called an inverted market, or one in backwardation. Inverted markets sometimes occur when
demand for the cash commodity is strong relative to its current supply. Inverted markets also occur
when the income from holding the cash position exceeds the costs of carrying the position--for
example, a U.S. Treasury bond futures position when long-term interest rates (the underlying
bonds' yield) exceed short-term rates (the cost of financing the cash bond portfolio).

Intermarket Spreads

An intermarket spread consists of a long position in one market and a

short position in another market trading the same or a closely related
commodity. An example is the "TED" spread--the difference between
the prices of a U.S. Treasury-bill futures contract and a Eurodollar time-
deposit futures contract--on the Chicago Mercantile Exchange. The TED
spread changes with changes in the relationship between short-term
interest rates for private and government debt. Another intermarket
spread is the "NOB" spread, or U.S. Treasury notes over U.S. Treasury
bonds, on the Chicago Board of Trade. This spread reflects the
difference in interest rates on U.S. Treasury securities of different
maturities. Other intermarket spreads include gold and silver as well as
platinum and palladium.

Examples of intermarket spreads on different exchanges are light sweet

crude oil futures at the New York Mercantile Exchange and Brent crude oil futures on the
International Petroleum Exchange or wheat contracts traded on the Chicago Board of Trade and
the Kansas City Board of Trade. Intermarket spreads often involve different grades or specifications
of a commodity, thereby introducing additional basis risk.

Also included among intermarket spreads are commodity-products spreads, which comprise a long
position in a commodity against short positions of an equivalent amount of the products derived
from the commodity, or vice versa. Examples are the soybean crush and the petroleum crack
spreads. A crush spread involves a long soybean futures position, representing the raw,
unprocessed beans, against short positions in soybean meal and soybean oil futures. The petroleum
crack spread involves purchasing crude oil futures and selling the products--heating oil and/or
unleaded gasoline futures.