Futures contracts are standardized agreements that are traded on
commodity exchanges that call for the future delivery of the commodity or
financial instruments at a specified time and place. A futures trader that
enters into a contract to take delivery of the underlying commodity is
"long" the contract, or has "bought" the contract. A
trader that is obligated to make delivery is "short" the
contract or has "sold" the contract. Actual delivery on the
contract rarely occurs. Futures traders usually offset (liquidate) their
contract obligations by entering into equal but offsetting futures
positions. For example, a trader who is long one September Treasury bond
contract on the Chicago Board of Trade can offset the obligation by
entering into a short position in a September Treasury bond contract on
that exchange. Futures positions that have not yet been liquidated are
known as "open" contracts or positions.
Futures contracts are traded on a wide variety of commodities,
including agricultural products, metals, livestock products, government
securities, currencies and stock market indices. Options on futures
contracts are also traded on U.S. commodity exchanges.
Currencies and other commodities may be purchased or sold for future
delivery or cash settlement through banks or dealers pursuant to forward
or swap contracts. Currencies also can be traded pursuant to futures
contracts on organized futures exchanges. Dealers in foreign exchange
contracts for currencies will act as "principals" in these
transactions and will include their profit in the price quoted on the
contracts. Unlike futures contracts, foreign exchange contracts are not
standardized. In addition, the forward market is largely unregulated.
Forward contracts are not "cleared" or guaranteed by a third
party. Thus, managed futures funds are subject to the creditworthiness of
the foreign exchange dealers with whom they maintain all assets and
positions relating to a fundís forward contract investments. There also
is no daily settlement of unrealized gains or losses on open foreign
exchange contracts as there is with futures contracts on U.S. exchanges.
Transactions in forward or other markets could be characterized as swap
transactions. They may involve interest rates, currencies, securities
interests, commodities and other items. A swap transaction is an
individually negotiated, non-standardized agreement between two parties to
exchange cash flows measured by different interest rates, exchange rates,
or prices, with payments calculated by reference to the amount of the
note. Transactions in these markets present risks similar to those in the
futures, forward and options markets. These risks include:
- the swap markets are generally not regulated by any United States or
foreign governmental authorities;
- there are generally no limitations on daily price moves in swap
- speculative position limits are not applicable to swap transactions,
although the counterparties with which a fund may deal may limit the
size or duration of positions available as a consequence of credit
- participants in the swap markets are not required to make continuous
markets in swaps contracts; and
- the swap markets are "principal markets," in which
performance with respect to a swap contract is the responsibility only
of the counterparty with which the trader has entered into a contract
(or its guarantor, if any), and not of any exchange or clearinghouse.
As a result, a fund will be subject to the risk of the inability of or
refusal to perform by its counterparty with which it trades.
The Commodity Futures Trading Commission (CFTC) has adopted Part 35 to
its Rules which provides non-exclusive safe harbor treatment from
regulations under the Commodity Exchange Act as amended for swap
transactions which meet specified criteria, over which the CFTC will not
exercise its jurisdiction and regulate as futures or commodity option
transactions. In addition, on December 21, 2000, the Commodity Futures
Modernization Act of 2000 amended the Commodity Exchange Act so that it
does not apply to any agreement, contract, or transaction in a commodity,
other than an agricultural commodity (including swap transactions), if the
agreement, contract, or transaction is entered into only between eligible
contract participants (which includes commodity pools meeting certain
capitalization requirements), is subject to individual negotiation by the
parties, and is not executed or traded on a trading facility. If a managed
futures fund were restricted in its ability to trade in the swap markets,
the activities of a fund, to the extent that it trades in such markets,
might be materially affected.
The U.S. futures markets are regulated under the Commodity Exchange
Act, which is administered by the CFTC, a federal agency created in 1974.
The CFTC licenses and regulates commodity exchanges, commodity pool
operators, commodity trading advisors and clearing firms which are
referred to in the futures industry as "futures commission
merchants." Futures professionals are also regulated by the National
Futures Association (NFA), a self-regulatory organization for the futures
industry that supervises the dealings between futures professionals and
their customers. If its pertinent CFTC licenses or NFA memberships were to
lapse, be suspended or be revoked, a managed futures fund manager would be
unable to act as the commodity pool operator and commodity trading
The CFTC and the exchanges have pervasive powers over the futures
markets, including the emergency power to suspend trading and order
trading for liquidation of existing positions only. The exercise of such
powers could adversely affect a fundís trading.
The CFTC does not regulate forward contracts. Federal and state banking
authorities also do not regulate forward trading or forward dealers.
Trading in foreign currency forward contracts may be less liquid and
therefore a fundís trading results might be adversely affected.
The CFTC has adopted disclosure, reporting and recordkeeping
requirements for commodity pool operators and disclosure and recordkeeping
requirements for commodity trading advisors. The reporting rules require
pool operators to furnish to the participants in their pools a monthly
statement of account, showing the poolís income or loss and change in
net asset value, and an annual financial report, audited by an independent
certified public accountant.
Many managed futures funds use margin in their trading. In order to
establish and maintain a futures position, traders must make a type of
good-faith deposit with its broker, known as "margin," of
approximately 2%-10% of contract value. Minimum margins are established
for each futures contract by the exchange on which the contract is traded.
The exchanges alter their margin requirements from time to time, sometimes
significantly. For their protection, futures brokers may require higher
margins from their customers than the exchange minimums. Margin also is
deposited in connection with forward contracts but is not required by any
There are two types of margin. "Initial" margin is the amount
a trader is required to deposit with its broker to open a futures
position. The other type of margin is "maintenance" margin. When
the contract value of a traderís futures position falls below a certain
percentage, typically about 75%, of its value when the trader established
the position, the trader is required to deposit additional margin in an
amount equal to the loss in value.