Futures

Roughly speaking, a futures contract is an agreement to buy (or sell) some commodity at a fixed price on a fixed date. Futures are commonly available in the following flavors (defined by the underlying "cash" product):

Commodity futures

A commodity future, for example an orange-juice future contract, gives you the right to buy (or sell) some huge amount of orange juice at a fixed price on some date.

Stock index futures

Since you can't really buy an index, these are settled in cash.

Interest rate futures (including deposit futures, bill futures and government bond futures)

These are usually settled in cash as well.

Futures are explicitly designed to allow the transfer of risk from those who want less risk to those who want more risk. They do this by offering several features:

1.      Liquidity

2.      Leverage (a small amount of money controls a much larger amount)  A high degree of correlation between changes in the futures price and changes in price of the underlying instrument.

This is usually ensured via the mechanism of basis trading. In the case of the commodity future, if I sell you a commodity future then I am promising to deliver X amount of the commodity to you at a given price (fixed now) at a given date in the future.

This means that if the price of the future becomes too high relative to the price of the commodity today, I can borrow money to buy the commodity now and sell a futures contract (on margin). If the difference in price between the two is great enough then I will be able to repay the interest and principal on the loan and still have some risk less profit i.e. a pure arbitrage.

Conversely, if the price of the future falls too far below that of the commodity, then I can sell the commodity short and purchase the future. I can (presumably) borrow the commodity until the futures delivery date and then cover my short when I take delivery of some of the commodity at the futures delivery date. I say presumably borrow the commodity since this is the way bond futures are designed to work; I am not certain that commodities can be borrowed.

Either of these 2 arbitrage trades are known as "basis trades" as you are trading the "basis" (don't ask me why it's called that) between the future and the underlying "cash product".