Prerequisites for Futures and Options on Futures Markets

Wherever there is price volatility, there is a potential need for futures and options on futures 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 on futures 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.