Basis

In a futures market, basis is defined as the cash price (or spot price) of whatever is being traded minus its futures price for the contract in question. It is important because changes in the relationship between cash and futures prices affect the value of using futures as a hedge. A hedge, however, will always reduce risk as long as the volatility of the basis is less than the volatility of the price of whatever is being hedged.

Backwardation

In a furures market the price of a contract for future delivery of, say, a commodity usually trades above the spot price because the notional interest received from holding cash rather than the underlying commodity is added to the cost of the contract. Sometimes, however, demand for the commodity pushes the spot price above the futures price. This is a backwardation, also known as an inverted market.

Arbitrage

To arbitrage is to make a profit without risk and, therefore, with no net exposure of capital. In practice, it requires an arbitrager simultaneously to buy and sell the same asset - or, more likely, two bundles of assets that amount to the same - and pocket the difference. Before financial markets were truly global, arbitraging was most readily identified with selling a currency in one financial center and buying it more cheaply in another. The game has now moved on a little, but, for example, there would be the potential to make risk-free profits if dollar interest rates were sufficiently high to allow traders to swap their euros for dollars and be left with extra income after they had covered the cost of their currency insurance by selling dollars forward in the futures market. Similarly, arbitrage opportunities can be exploited by replicating the features of a portfolio of shares through a combination of equity futures and bonds then simultaneously selling the actual stocks in the market. (See risk arbitrage)