Contracts for Difference (CFDs) from a fund accounting perspective
Here is your primer on contracts for difference (CFDs).
You can watch the video here.
What is a CFD? What is a contract for difference? A contract for difference, or CFD, is an over-the-counter (OTC) contract between two parties whereby one party pays the other party an amount determined by the difference between the opening and closing price on the contract.
The price at which a particular CFD contract is traded and the price at which it is valued depends on the underlying asset. The underlying asset could be a bond, a currency, a commodity, an index or an equity. Let’s look at an equity CFD trade.
Quick Limited is trading at €10 per share. The investment manager could buy 10,000 shares at a cost of €100,000. Or he could open a CFD position. One of the advantages of trading CFDs, like many derivatives, is that they are traded on margin. In other words, you don’t have to pay the full cost of the underlying asset. You only have to pay what is called initial margin to open the position. Thereafter, variation margin movements between the counterparties reflect changes in the value of open positions. Margin is basically collateral.
The investment manager thinks Quick Limited will appreciate in value over the coming days. He creates a LONG CFD position by executing a BUY TO OPEN (OPEN LONG) and he buys 10,000 CFDs. In this particular case, CFD broker requires a 10% initial margin payment. So the fund must pay the broker €10,000.
So, the fund bought 10,000 Quick CFDs at a price of €10. Ten days later, the investment manager decides to close the position (CLOSE LONG).
Quick has increased significantly in the meantime; the share is trading at €12 and the fund closes the CFD position at €12. So the fund realises a gain of €20,000.
But there is an expense we need to consider. The fund is making a €100,000 notional investment but is only paying margin of €10,000. It is as if the CFD broker is financing the CFD investment. As you’d expect, the CFD broker charges the fund for financing. So there is an interest expense associated with a long position such as the one shown here. The rate of interest is usually tied to a benchmark market rate. For our example will assume interest of 3%. This is calculated daily based on the value of the open position.
Also for simplicity sake, we just have one calculation here whereas in reality, this is a daily calculation.
Some brokers might charge commission or stock lending fees so watch out for additional fees on the broker statement.
So that fund was bullish on Quick Limited so created a long CFD position. The same investment manager holds a negative view on Slow Limited. Slow is trading at €20 per share. Thinking that the price will fall, the fund executes a SELL TO OPEN (OPEN SHORT) and thus creates a SHORT position. The fund sells 5,000 CFDs.
So, the fund sold 5,000 Slow CFDs at a price of €20. Five days later, the investment manager decides to close the position (CLOSE SHORT).
Slow has fallen in value and the share is trading at €18 and the fund closes the CFD position at this price. So the fund realises a gain of €10,000.
Remember the long position earlier and the fact that it incurred interest expense? Well a short position earns interest income. The rate here is 2%.
Let’s go back to the LONG position of Quick. The fund enjoys the benefits of owning Quick shares without actually owning the shares. It just has this CFD position. What if Quick had a dividend go ex while the fund had a long CFD position? Long equity CFD positions earn dividend income on ex-date. So the CFD holder earns the dividend income. Similarly, with the SHORT position in Slow Limited, if Slow went ex while the fund held that short CFD position, then the fund would incur a dividend expense. Dividends are considered in more detail in the online course Fund Accounting for CFDs.
In the previous examples, the fund kept the positions open for just 10 days and 5 days respectively. What would happen if the fund kept the positions open for much longer. Unlike futures contracts, CFDs do not have an expiry date. Unlike swaps, CFDs do not have a maturity date. CFD trading usually has a facility to allow the counterparties to receive some cash to reflect the gains made to date. Or pay cash when losses are incurred. In other words, counterparties to CFD trades are usually able to crystallise gains and losses without having to wait for the position to be closed. Let’s reconsider the long position of Quick CFDs. This time, the counterparties have an agreement to reset the position on a weekly basis. Let’s see what happens.
To recap, the fund bought 10,000 CFD at €10 and held them for 10 days. At the end of day 7, the equity market price is €11 so the CFD position is valued at €11. At this point, the position is RESET. This means that, even though no trade is done, the broker closes the position at €11 and re-opens the position at the same price. This has the effect of realising the gain and interest expense and, if there was a dividend accrual, that would also be realised.
Most, but not all, CFD trading, involves regular resets. If there are no resets, gains, losses, income and expenses are realised on settlement and pay dates. Throughout the online course, Fund Accounting for CFDs, we’ll discuss the most common situation, that is, where regular resets occur. But do bear in mind that, for some CFD accounts, no resets are done at all.
Why trade CFDs?
CFDs allow investors gain exposure to assets without actually owning the assets. The investor can create a long or a short position, depending on their outlook or objective. Unlike trading equities in some jurisdictions, there is no stamp duty involved in CFDs. And CFDs are traded on margin.
So the investor can use CFDs to create an economic exposure much greater than the amount of the actual cashflow.
- CFDs are over-the-counter derivatives that allow investors gain exposure to equities, bonds, indices, currencies and commodities.
- Unlike futures, they do not have an expiry date.
- Long positions can earn dividend income and incur interest expense.
- Short positions do the opposite.
- Positions are usually reset regularly and the reset means gains and losses, income and expenses are realised and result in a cash flow.