Cfd Case Study

CFD – Contract for Difference

A contract for difference or as more commonly referred to as CFDs are a popular financial derivative instrument used by wide range of people for different purposes. Essentially a CFD is a futures contract on a certain asset such as shares in a company, price of a commodity or any other financial instrument. It allows the purchaser of the CFD (or seller) to buy (or sell) the asset without actually owning directly. The transaction is made with the use of a market maker provider that tries to match the transaction, be it buying or selling, with the opposite trade. However because the CFD is a derivative of the actual asset, the buyer or seller may not exist on the platform the trade is made. In this case the market maker provider will match the buy or the sell taking on the risk. For each trade the market maker will charge a small transaction fee. On top of the transaction fee the market maker will leverage all trades depending on the asset that is traded.

For example; trader A purchases 100,000 CFDs in the Company XYZ at $1.00 per share

The spread on XYZ at the given transaction time as below:

BUY XYZ $0.99c

Sell XYZ $1.00

Because trader A is the buying at the market rate he buys at the sell rate of $1.00 per CFD

$1.00 x 100,000 CFD’s = $100,000

The Margin requirement on company xyz is 5% .

Trader A is only required to put in $5,000 capital and the market maker makes up the remaining $95,000. The market maker charges an interest rate normally linked to the OCR . In this case 3%(OCR) +2%. This is is referred to as the holding cost.

Trader B has made a trade for arguments sake to sell 100,000 CFDs in company XYZ. The same margin rules apply to trader B however he is credited interest at a rate of ...

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... be borrowed in the real market, it is possible to hedge with a lot less capital.

An example of using CFD’s to hedge against currency;

Company A is based in New Zealand and expects to receive 100,000 pounds from a UK based company in 2 months’ time for design and build of some equipment. Company A has fixed costs in NZD and at the time on the contract signing worked out the cost in NZD.

Company A would like to hedge against the fluctuation of the sterling. To do this they buy 100,000 sterling in the CFD market. In this case currency has a 1% margin so the capital they require to make the trade is 1,000 Sterling or 1960NZD ( at an exchange rate of 1.96)

The cost to Company A to maintain this hedge is ;

100,000 (sterling) x 1.96 (exchangerate) = $196,000nzd

@ 5.5% interest ( OCR +2.5% margin) - $10,780 per year

$29.54c per day + any margin call requirements.