Contracts for Difference The Works

Transcription

1 Contracts for Difference The Works C-thesis in Economics School of Business Mälardalen University Author Mikael Persson Tutor Professor Johan Lindén 1

2 1 Summary C-thesis, Mälardalen School of Business Financial product analysis, spring term 2007 Author: Mikael Persson Tutor: Professor Johan Lindén Title: Contracts for Difference The Works 1.1 Background and problems There are many financial products available to investors in the modern world of today. One group of financial products has grown most in recent years and has today become an important part of today s financial markets. These ranges of financial products are called derivatives. The demand for derivatives has increased tremendously since the 1970s and the products alone have created several new markets each generating a turnover of hundreds of billion dollars a year. The cause of this development is a result of investors wanting to invest in something other than more traditional financial products like stocks or bonds. Because of the fast development of these derivative products the need for information about the products increases as well. One of the latest financial derivative products to hit the market is Contracts for Difference or CFD for short. CFDs became available to private investors in and the product has since then skyrocketed and it is estimated that CFDs account in the United Kingdom for about one third of the entire volume on the London Stock Exchange. About a year ago CFDs were introduced to Swedish investors via companies such as CMC Markets and E*trade. CMC Markets was in fact the first company to offer CFDs to Swedish investors. Because CFDs are quite new to the Swedish market little research has been done on how investors use the product. CFDs were initially invented as a tool to reduce risk in portfolios but does that mean private investors also use CFDs for hedging or are they used in a different purpose? The problem with new products is that they are always delivered with a whole lot of questions

3 1.2 Purpose The purpose of this thesis is to determine how private investors use CFDs, how they use CFDs compared to their regular trading behaviour and whether or not private investors use CFDs in risk management situations. The thesis will also explain the concept of CFDs since it is a fairly new financial instrument and has not been around for that very. It will explain how the pricing of CFDs work, what risks that are associated with CFDs, key terms important to understand by CFD traders and some strategies that can be used when trading CFDs. 1.3 Delimitation Since the area of study is quite broad some parts relating to CFDs will be left out. A complete market analysis of CFD market will not be done. Comparisons between different national CFD markets will not be discussed. Since the thesis seeks to explain CFD trading behaviour among private investor the institutional or company point of view will be left out. 1.4 Method Through a survey directed to Swedish CFD traders I wanted to determine the trading behaviour of the survey participants and see if the result matched the theories discussed in the thesis. Through an extensive search of sources relating to CFDs in form of books, newspaper articles, web articles, company websites, and so on I described CFD as a product as well as explain key terms relating to CFD. 1.5 Analysis and end notes The conclusion of the survey was that investors use CFDs as a complementary products as supposed to as a substitute product, and that investors do use CFDs to manage the risk of their portfolios. Not as a mean to reduce risk through hedging but as a way to increase risk by taking advantage of the leverage that the product offer. The survey also concluded that CFD traders are quite risk tolerant and that CFD traders use the product as a short term instrument. 3

4 1.6 Suggestions for further research It would be quite interesting to go into a more in depth analysis of investor behaviour regarding CFDs. To determine why there is an increased need to expand the risk of the portfolio rather than to reduce it. It would be interesting to find out if the current state of economy has any impact on how investors use CFDs. Perhaps more investors would use them as a hedging tool in economic downtrends or recession. It would also be interesting to find out how CFDs affect the portfolio when it comes to rate of return. Another interesting approach would be to compare how private investors use CFDs and how institutional investors use CFDs. 4

5 Table of contents 1 Summary Background and problems Purpose Delimitation Method Analysis and end notes Suggestions for further research... 4 Table of contents Introduction Background Problems Purpose of thesis Structure of the thesis Use of terms Literature review What is already known? Why is it interesting? Method Quantitative and qualitative methodology Quantitative methodology Qualitative methodology Applied methods Theory and questions Questions The separation principle Contracts for Difference Explanation of terms Over-the-Counter (OTC) markets Margin, maintenance margin and the margin call Spread Hedge History of CFD The product The hedger and the speculator Pricing CFDs CFD as a leveraged instrument Costs Comparison between other derivatives and CFDs Equity sway Futures contracts Shares Options

6 7 Risk management Introduction to risk management Risk management relating to CFD trades Limit order Stop-loss order One cancels the other (OCO) order If done order Guaranteed stop-loss order Concept of hedging CFD and hedging Risks with hedging Trading strategies Strategies useable to a CFD trader Pairs trading Hedging Selling short Dead cat bounce Tax efficient strategies Private investor survey About the survey Result and analysis of the survey Summarization Conclusion Summarization Conclusions List of sources Appendices

7 2 Introduction This introductory chapter will give the reader a brief introduction as to why this particular area of study has been chosen. The chapter will also explain some problems relating to the area of study and it will also explain the purpose with the thesis in more detail. 2.1 Background During the last couple of decades from the 1970s till today the financial market has seen a great evolution in financial products. Many new products to hit the financial market have been products that base their result on other financial products, these products are called derivatives. Options, futures, warrants and CFDs are all example of derivative products. These derivative instruments have become very popular for investors as an alternative to the more traditional instruments such as stocks and bonds. Most derivative products if not all were initially created by financial institutions. Most financial institutions used the derivatives to hedge away risk in investments. Some derivative products like futures contracts for example also gave financial institutions the possibility to take positions in an underlying asset without having to actually own the asset itself. Some derivative products also made it possible to leverage investments. Also derivatives were not initially created for private investors. Today conditions have changed and many private investors use derivative products in their investment portfolios, much in the same sense as financial institutions did and still do, that is either to hedge out risk or to increase risk. Many derivative products are also trading on their own markets, which means by fact that financial institutions have created more markets for people to act on. Some derivative products are traded on auction markets and other derivative products are traded on dealer markets created by market makers. Options are for example traded on an auction market, the same goes for futures contracts while warrants and CFDs are traded on dealer markets. One of the latest financial derivative products to hit the market is Contracts for Difference or CFD for short (mentioned above). CFDs became available to private investors in and the product has since then skyrocketed and it is estimated that CFDs account, in the U.K. for about one third of the volume on the London Stock Exchange 3 CFDs have become very popular in many parts of the world including Europe, Asia and Australia. It was originally invented in the U.K. in the 1980s but how has found its way to Swedish investors. CFDs are interesting in the sense that they appeal more to private investors than perhaps any other derivative instrument because of their price transparency and because they are easy to use and understand. There are at the moment no Swedish companies that offer CFDs to their customers. In 2006 the Swedish brokerage firm United Brokers started to offer Swedish investors the possibility to trade CFDs through their partner CMC Markets, a London based financial institution. Since the establishment of CMC Markets in Sweden through United Brokers many other CFD market makers have started offering the product to 2 Ibid. 3 FT.com, London, Mar 16, 2007, p.1 7

8 Swedish investors. As an investor you are now able to sign up with CMC Markets, E*trade, IG Markets, Saxo Bank and other financial institutions. Although there are no Swedish financial institutions offering CFDs it is my guess that it will not stay that way for long. As the demand for the product increases so does the interest to offer the product and so does the interest of knowing how investors use the product and why it appeals to them. This is exactly why the area of study has been chosen. 2.2 Problems Today many investors see CFDs as a regular part of their overall portfolio and within a couple of years maybe even so for Swedish investors. Since the contract were initially created for hedging there might be a reason to assume private investors will use the contract for that purpose as well. Many professional investors also claim CFDs are interesting because they offer an easy way of gearing and it is easy to short sale underlying assets with CFDs. Could this perhaps be one of the main reason to why the product has become so popular among private investors or is there another reason? If CFDs are used to hedge or to gear it could mean it is a complementary product, i.e. a product used as a compliment to the rest of the investments. Would then private investors also use it as a compliment or would they give up other investments to only trade CFDs? Another problem is that there are not a lot of information about CFDs compared to other derivative products. In many books on the subject of investment or derivatives CFDs are rarely mentioned. This is of course due to the fact that CFDs is a relatively new product. I am yet again guessing but I would expect CFDs to have a natural place amongst the derivative products in future books about the subject. The result of the lack of information is of course that its hard for investors to get a grip on the product. An interested investor cannot simply go to the average library and read about them. Although there is information about CFDs on the internet it is not the first source of information for everyone. All in all there are some standpoints or questions this thesis seeks to find answers to. Five questions have been listed and the aim is to answer all of them. Do private investors use CFDs as a complement to their other investments? How do private investors use CFDs to manage risk? How do private investors trade CFDs compared to trading stocks? What makes CFDs an interesting competitor to other similar products? How does private investors trading behaviour relate to the separation principle? 8

9 2.3 Purpose of thesis The purpose of the thesis is to try and answer the questions posted in the previous section. To see how private investors behave when trading CFDs, how CFDs are used in risk management situations and describe the product itself. 2.4 Structure of the thesis The thesis is structured into three different parts covering four chapters. Part one include chapter six and describe the product and its history. In part one central key concepts will be explained and a comparison between similar derivatives and CFDs will be made. Part two covers chapter seven and eight and deal with risk management and strategies. The chapters describes how investors can use tools when trading CFDs to manage their risk, how the product itself can be used to manage the risk of a portfolio and what strategies investors can use when trading CFDs. Part three consist of chapter nine. This is the survey of investors trading CFDs. The result of the survey will be presented and an analysis of the answers and results of the survey will be concluded as well a summarization. The final chapter is the conclusion which will summarize the entire thesis. 2.5 Use of terms Throughout this thesis some terms will be used subsequently with one another. The term broker will in this thesis be equivalent with market maker and the term CFD provider will be equivalent with the term CFD market maker. A private investor in this thesis refers to a person who trade in his own interest and not in someone else s. Throughout the thesis the term investor will be the same as the term private investor. 9

10 3 Literature review This chapter will describe what is known about CFDs and what types of information that is available about CFDs. The chapter will also explain why the author of this thesis took an interest in the product and why he chose to write about it. 3.1 What is already known? Not much is written about CFDs in terms of literature. There are according to my findings only one book that totally devotes itself to CFDs. The book is called Contracts for Difference: Master the Trading Revolution and it is written by Catherine Davey. In this book Catherine describe the product in depth and also describe various trading strategies which investors can implement when trading CFDs and how investors can hedge with CFDs. The book is quite significant and the author has been supported by the CMC Group which is the financial institution who was first to offer CFDs to private investors. A search on Amazon.com about Contracts for Difference gave only one hit which is the book mentioned above. At another large bookstore, three hits came up when searching for CFDs. As a Swedish citizen I also searched all Swedish online bookstores and regular bookstores. There was not a single book to be found in their stock or on their order list which describes CFDs. When turning to the world s largest source of information, the World Wide Web I found a number of sites explaining CFDs. One particular site ( has published quite a lot of information about CFDs although the website is quite tricky to navigate. A search on contracts for difference on Google.com gives results of which an absolute majority will take you to a CFD market maker. Most market makers have some information about the contracts on their website but it is often quite shallow and not very descriptive. Next I went on searching some of the world s largest databases for information about CFDs, including ABI/Inform, JSTOR, Emerald, Business insights report and EBSCO. A few articles on the subject came up and the majority of the articles were published in the Financial Times or on the financial times website. As far as behavioural research about CFDs I could find no information at all and I did not find a single study of the contracts either. This struck me as being quite odd and actually frightened me a little when deciding to write about the subject. I thought there must be a reason as to why there are such little information about the product published but perhaps there are lots of information at hand its just really hard to find. 3.2 Why is it interesting? As stated in the introduction the problem or rather the need for explanation about the contract is needed. I have myself been trading CFDs for about one year and I have taken an interest in the product but I have not seen lots of great sources of information about it. I wanted to know more about the product and to find out how the product can be used for investors. I wanted to take a theoretical approach to the subject. Explaining the conept for people who are interested in the product and also to see how other investor used the product. 10

11 4 Method This chapter will explain the concept of methodology important and related to the thesis. The chapter will also explain how the methods described will be used throughout the thesis. The aim of this chapter is to allow for readers to follow what has been done to construct the thesis. The two parts which will be described are Quantitative methodology and Qualitative methodology. 4.1 Quantitative and qualitative methodology Methodology is defined as the analysis of the principles of methods, rules, and postulates employed by a discipline". It can also be defined as "the development of methods, to be applied within a discipline" or even as "a particular procedure or set of procedures". There are many theories and concepts relating to the subject of methodology. In fact one could state that methodology is in itself a subject worth of studying. Not all parts included in the science of methodology will be described but the two methods relating to this thesis. In Alan Brymans book Samhällsvetenskapliga metoder or Social scientific methods Alan describes two important parts of methodology. These parts are called quantitative methodology and qualitative methodology Quantitative methodology Quantitative research is the systematic scientific investigation of quantitative properties and phenomena and their relationships. Quantitative research is widely used in both the natural and social sciences, from physics and biology to sociology and journalism. The objective of quantitative research is to develop and employ mathematical models, theories and hypotheses pertaining to natural phenomena. The process of measurement is central to quantitative research because it provides the fundamental connection between empirical observation and mathematical expression of quantitative relationships. Quantitative methodology includes structured interviews, surveys, questions positions, structured observations, content analysis and secondary analysis. 11

12 4.1.2 Qualitative methodology Qualitative methodology is the other of the two major approaches to research methodology in social sciences. Qualitative research involves an in depth understanding of human behavior and the reasons that govern human behavior. Unlike quantitative research, qualitative research relies on reasons behind various aspects of behavior. Simply put, it investigates the why and how of decision making, as compared to what, where, and when of quantitative research. Hence, the need is for smaller but focused samples rather than large random samples. From which, qualitative research categorizes data into patterns as the primary basis for organizing and reporting results. Both Quantitative and Qualitative methodology principles will be implemented throughout the thesis. Quantitative methodology will be used extensively in the first part of the thesis whereas the last part which is the analysis of investor behavior will fall under Qualitative methodology. 4.2 Applied methods To determine how private investors use CFDs a survey will be constructed and sent out to various CFD market makers active on the Swedish market. The companies will in turn send out the survey to their customers. The survey is in electronic form and completely anonymous. It will not be possible do determine whichever investor who has filled out the survey. The survey will then be published through an online survey provider who can summarize the results. The survey was constructed with guidance of Alan Brymans principles on surveys. The survey was also constructed in such a way as to get the most out of how investors behave when trading CFDs. The method of survey was chosen over interviews because the fact that it is meant to reach lots of people. In that way surveys are cheaper and are more easily to administer than interviews. The pros and cons of surveys compared to multiple interviews have been under careful consideration before the method was chosen. To make a description of the product I will begin by going through various sources of information relating to CFDs such as newspaper articles, books, interviews and web articles. After enough information about CFDs have been collected and after cross examining different references the product will be described. I will summarize the result of the sources and make the description of the product as accurate as possible. In order to make it easier to understand CFDs key concepts will be explained. The decision why these key concepts have been chosen will be based on opinions from various CFD market makers as well as my own opinions. In determining how investors can manage their risk when trading CFDs as well as how CFDs can be used to manage risk the same approach will be applied. Here sources such as books and web articles discussing risk management will be used. Information from these sources will be extracted and applied to CFDs. Different trading strategies will be determined by searching for sources discussing the subject. Here CFD market makers and web articles will help in determining which strategies seems most important to CFD traders. Popular strategies useable by other derivative products will also be studied and examined to see if they can be applied to CFD trading. 12

13 5 Theory and questions This chapter will explain some of the theories and ideas to which this thesis is based. Because this is a thesis which will incorporate lots of theoretical parts, mathematical approaches will be limited. In the following section each of the problems formulated in chapter two will be discussed in more detail and an analysis of the capital market theory will be discussed. 5.1 Questions Do private investors use CFDs as a complement to their other investments? It is believed that most private investors use derivatives as a compliment to more traditional assets such as stocks and bonds. It is not uncommon that investors who trade in options also trade stocks. An investor trading futures or forward contracts might also be in the business of trading on the underlying asset. Because most financial institutions demand that an investor must have had experience in other financial instruments before trading CFDs it indicates that CFDs would in fact be used as a complementary product but it is so for the majority of the investors? How do private investors use CFDs to manage risk? When thinking of risk management or rather managing risks most people would think of the method to lower investment risk. There are however two ways in which an investor can manage her risks. An investor can either take actions to increase the risk of her investments or take actions to decrease the risk of her investments. In what way then do investors use the contracts? Many market makers claim CFDs are a great hedging tool but is that how investors use CFDs? How do private investors trade CFDs compared to trading stocks? Most CFD market makers will argue that CFDs are a short-term instrument. This means that it is a product in which investors would only hold for a short period of time. This question seeks to explain if investors hold stock position longer than CFDs, if investors have different attitudes towards risk between CFDs and stocks and if investors trade more CFDs than they trade stocks. What makes CFDs an interesting alternative to other similar products? Since there are so many other derivative instruments on the market there has to be some reason as to why investors find CFDs so interesting. As will be described later on there are other similar products that can in a sense act as a substitute to CFDs. An investor need for example not trade CFDs to leverage his or her investments. If an investor wanted to hedge his or hers present position she could use options or perhaps futures contracts. 13

14 How does private investors trading behaviour relate to the separation principle? Since CFDs are leveraged instruments it would mean investors are more tolerant towards risk than other investors who prefer safe investments. Would they be more tolerant to risk when it comes to trading CFDs compared to trading stocks, would it be any changes? 5.2 The separation principle James Tobin (1958) added the notion of leverage to portfolio theory by incorporating into the analysis an asset which pays a risk-free rate. By combining a risk-free asset with a portfolio on the efficient frontier, it is possible to construct portfolios whose risk-return profiles are superior to those of portfolios on the efficient frontier. Using the risk-free asset, investors who hold the super-efficient portfolio may: leverage their position by shorting the risk-free asset and investing the proceeds in additional holdings in the super-efficient portfolio, or de-leverage their position by selling some of their holdings in the super-efficient portfolio and investing the proceeds in the risk-free asset. The resulting portfolios have risk-reward profiles which all fall on the capital market line. Accordingly, portfolios which combine the risk free asset with the super-efficient portfolio are superior from a risk-reward standpoint to the portfolios on the efficient frontier. Tobin concluded that portfolio construction should be a two-step process. First, investors should determine the super-efficient portfolio. This should comprise the risky portion of their portfolio. Next, they should leverage or de-leverage the superefficient portfolio to achieve whatever level of risk they desire. Significantly, the composition of the super-efficient portfolio is independent of the investor's appetite for risk. The two decisions: the composition of the risky portion of the investor's portfolio, and the amount of leverage to use, are entirely independent of one another. One decision has no effect on the other. This is called Tobin's separation theorem. 4 In a world with all the assumptions made so far, all individuals should hold the market portfolio levered up or down according to their degree of risk tolerance. A person with low risk tolerance (high risk aversion) will have most of her money in the risk free

15 security thereby placing herself left of A in the picture below while a person with high risk tolerance (low risk aversion) will borrow to finance the purchase of the market portfolio thereby placing herself on the right side of A. 5 Relating to the last question will CFD investors prefer higher risk thereby placing them beyond A on the capital market line or if they prefer less risk placing them on the other side of A towards the risk-free rate

16 6 Contracts for Difference This chapter will explain what CFDs are and how they work. The chapter will explain key concepts relating to CFDs. The chapter will begin by explaining terms relating to CFDs, followed by the history of CFDs, the development from then to know and then explain how CFDs work, how they are priced and where they are traded. Finally there will be some comparison between existing derivative products and CFDs. 6.1 Explanation of terms Over-the-Counter (OTC) markets Just as financial institutions come into existence as natural responses to investor demands, so too do markets evolve to meet needs. According to Bodie, Kane and Marcus 6 we can differentiate between four types of markets: direct search markets, brokered markets, dealer markets, and auction markets. CFDs are a part of the dealer market which is where OTC markets belong. In dealer markets dealers specialize in various assets, purchasing them for their own inventory and selling them for a profit from their inventory. The dealer s profit margin is the bid-asked spread the difference between the price at which the dealer buys for and sells from inventory. Dealers in dealer markets can also be called market makers. The definition of a market maker according to Investorwords.com is A brokerage or bank that maintains a firm bid and ask price in a given security by standing ready, willing, and able to buy or sell at publicly quoted prices (called making a market). Market makers are very important for maintaining liquidity and efficiency for the particular securities that they make markets in. At most firms, there is a strict separation of the market-making side and the brokerage side, since otherwise there might be an incentive for brokers to recommend securities simply because the firm makes a market in that security Margin, maintenance margin and the margin call The definition of margin according to the Merriam-Webster dictionary is the following: (1) : cash or collateral that is deposited by a client with a commodity or securities broker to protect the broker from loss on a contract. (2) : the client's equity in securities bought with the aid of credit obtained specifically (as from a broker) for that purpose. 6 Zvi Bodie, Alex Kane, Alan J. Marcus, Investments, McGraw Hill, International Edition, 6 th Edition

17 When it comes to margin and CFD margin can be said to be when you make a deposit to secure a trade and borrow money from the brokerage for the rest of the trade. The broker in turn, borrows money from banks at the call money rate to finance these purchases, and charges its clients that rate plus a service charge for the loan. By borrowing money to invest in additional securities, bigger positions can be held and thus the buying power increases. There are three important aspects of margin trading; the initial margin, the maintenance margin, and the margin call. Every market maker or brokerage have a limit to how low you margin level can go. This is called maintenance margin which is the amount you need to maintain on your account after a trade. In volatile markets, prices can fall very quickly. If the equity in the investors account falls below the maintenance margin, the brokerage will issue a margin call. A margin call forces the investor to either liquidate her position in the asset or security or add more cash to the account. An example will bring some clarity. Let's say an investor purchase SEK worth of securities by borrowing SEK from her brokerage and paying SEK herself. If the market value of the securities drops to SEK, the equity in her margin account falls to SEK ( = ). Assuming a maintenance requirement of 20%, the investor must have 5000 SEK in equity in her account (20% * = 5000). Thus, she would be fine in this situation as the SEK worth of equity in the account is greater than the maintenance margin of 5000 SEK. But let's assume the maintenance requirement of her brokerage is 45% instead of 20%. In this case, her equity of SEK is less than the maintenance margin of SEK (45% * = ). As a result, the brokerage will issue a margin call. If the investor for any reason does not meet the margin call, the brokerage has the right to sell the investors securities to increase her account equity until she is above the maintenance margin. The advantage of trading on margin is of course the ability to leverage or gear the investment Spread The difference between the current bid and the current ask (in over-the-counter trading) or offered (in exchange trading) of a given security; also called bid/ask spread Hedge An investment made in order to reduce the risk of adverse price movements in a security, by taking an offsetting position in a related security. 17

18 6.2 History of CFD Contracts for Difference or CFD for short, is a financial derivative product invented in the 1980 s in the United Kingdom. It has evolved from another financial derivative called Equity Swaps (reference CFD book). The purpose of CFDs was at first to be used as a tool for financial institutions to hedge positions in underlying assets. Although CFDs have been around for well over ten years it was not until 2003 that CFDs became available to private investors. Although the instrument was invented in the U.K. its use has spread to many countries across the globe According to the Financial Times. CFDs now account for one third of the entire volume traded on the London Stock Exchange (LSE). There are probably many reasons as to why CFDs have become so popular. However I believe on of the greatest reasons is, and this applies to all derivative instruments, is because financial institutions have created environments that are conductive to the efficient use of derivatives. This environment depended heavily on the explosion in information technology witnessed in the 1980s and 1990s. Without enormous developments in computing power, it would not have been possible to do the numerous and complex calculations necessary for pricing derivatives quickly and efficiently and for keeping track of positions taken. In fact, one would argue that the development of the personal computer was one of the single most important events for derivatives. Today almost all if not all companies providing CFDs also provide an online trading platform on which its customers can trade on around the clock. 6.3 The product A CFD is a financial derivative instrument which is traded on an over-the-counter market through a market maker. Since it is a derivative instrument, its return is derived from those of other financial instruments such as stocks, indexes or futures contracts. The price of a CFD is therefore said to be based on an underlying asset. Although there is no standardized definition of a CFD perhaps the closest explanation is; A CFD is an agreement between two parties to exchange, at the close of the contract, the difference between the opening price and the closing price of the contract. The holder of a CFD gets access to the performance, or price movements of the underlying asset, without having to take delivery of the actual asset (reference cfd book). 18

19 6.3.1 The hedger and the speculator Because the prices on derivative products are related to the prices of the underlying spot market goods, they can be used to reduce or increase the risk of owning the spot item. Derivative market participants seeking to reduce their risk are called hedgers. Derivative market participants seeking to increase their risk are called speculators. There are therefore two types of investors trading CFDs, the speculator and the hedger. A hedger holds a position in the spot market. By taking a position in a CFD contract negatively correlated to the position in the spot market the hedger reduces the risk. Speculators on the other hand attempt to profit from guessing the direction of the market. This means that derivative markets enable those investors who wish to reduce their risk to transfer it to those wishing to increase it. For this purpose speculators play an important role in the market by providing the liquidity that makes hedging possible and assuming the risks that hedgers are tying to eliminate Pricing CFDs The price of a CFD always mirrors the price of the underlying asset; this result in a simple pricing formula. The price of a CFD trade: The unit value of the underlying asset * the percentage deposit requirement * number of contracts If for example an investor were to buy 1000 CFDs in Ericsson and the Ericsson stock were trading at 25 SEK per share, at 10 % margin the price of the position would be; 25 SEK * 0,10 * 1000 = 2500 SEK The above formula will calculate the price of any CFD position. The same formula also calculates how much an investor must put down as a deposit in order to make the trade. Would the investor hold the position for more than a day she would have to pay a financing charge on the loan she is in fact taking to cover the whole position. Example: Let s say during the day Ericsson is traded up to 26 SEK per share. The price of buying 1000 CFDs is according to the above formula 2600 SEK. Say our investor decides to sell his position of 1000 CFDs in Ericsson. The amount credited to her account would not be the difference between 2500 and 2600 SEK but the difference between and SEK which is 1000 SEK. The balance of the account after the transaction would be 3500 SEK (assuming a starting balance of 2500 SEK). This is because CFDs are leveraged instruments, when trading on 10 % margin all gains or losses are multiplied by ten. 19

20 Some market makers offer commission free trading. To cover their costs of providing commission free trading these market makers usually have slightly wider spread on their CFD trades. The price of the CFD might not exactly mirror the underlying market but might differ slightly. CFD pricing is said to be the same as the spread quoted on the underlying exchange which also means the size of the spread quoted will directly affect the cost of trading CFD. Despite the fact that some market makers have wider spread on their CFDs than on the underlying asset the price transparency on CFDs are better than other derivative instruments CFD as a leveraged instrument CFDs are said to be leveraged or geared instruments which means when trading CFDs the investor trade on a margin account. In other words CFDs are said to be collaterally financed. The deposit is not a down-payment in order to pay for the balance of trade but is a margin held by the market maker as an insurance against possible losses. Because a CFD is a leveraged instrument investors have to pay a financing cost for the positions held are they held overnight (more about costs later on). If an investor would be able to trade on a 10 % margin, which is not an unusual margin level among many CFD market makers, she would need to put up 1/10 of the amount in cash to secure the entire position. For example SEK in a CFD account would enable the investor to hold positions for SEK (20 000*10 = ). Increased leverage, or gearing, can increase the return on the investment dramatically. If an investor were to trade on 10 % margin as above the investors return would be tenfold compared to if she were not leveraged. If the price on an underlying would increase for example 1 % then her return would be 10 %. Of course this work both ways, a loss of 1 % on the underlying is a loss of 10 % on the CFD position. Common margins among CFD market makers are 20, 10 and 5 % margin and sometimes even less for sector trades and indexes Costs There are (at most market makers) two costs important to know about. First there is the brokerage rate. This rate varies between CFD providers. It can be a fixed cost per trade or a percentage of the underlying value of the trade. Secondly is the financing charge. The financing charge is only occurred if a long position is held overnight. The rate at which the investor is charged is determined by the CFD provider. This rate is usually based on the official cash rate in the underlying market plus a small margin or a service charge. (cfd book p.18) The investor would have to pay interest on 100 % of the value of the underlying position. There are no deductions from the margin paid to secure the trade. That is because the margin is not a down-payment but a security held by the CFD provider to protect against possible losses. 20

21 The financing charge or cost exist because if the CFD provider decides to directly hedge the CFD position in the underlying market the CFD provider would have to use their own capital to fund 100 % of the position. In a sense the CFD provider can be said to fund the investors deal. Because of the financing charge CFDs can be quite costly to hold for longer periods of time and are therefore said to be a short-trade derivative instrument. Just as taking a long position is equivalent of borrowing money taking a short position is equivalent of lending money. If an investor were to shot sell she may receive interest on the total value of the position at the market rate. The CFD provider can use the short position to offset other opposite positions. 6.4 Comparison between other derivatives and CFDs CDFs share some similarities with other derivative products on the financial markets. This part will describe some similarities among derivative products and CFDs and to better understand how a particular financial instrument works, it s a good idea to know where it has originated from Equity sway The definition of a swap: A swap is a financial derivative in which two parties make a series of payments to each other at specific dates There a various types of swaps such as interest rate swaps, currency swaps and equity swaps. Equity swaps are very similar to CFDs in a sense that In an equity swap at least one of the two streams of cash flows is determined by a stock price, the value of a stock portfolio, or the level of a stock index. An equity swap can therefore be substitute for trading in an individual stock, stock portfolio or stock index. For an equity swap in which a party pays the return on the stock and receives a fixed rate, the cash flow will be: (Notational Principal) ((Fixed rate)q Return on stock over settlement period) Where q is the fraction of the year period and is known as the accrual period The value of an equity swap can be found finding the value of a portfolio of a stock and a loan that replicates the payments of the swap. 21

22 Financial institutions are using equity swaps because it gives them the opportunity to trade a specific stock, portfolio, or index without having to actually own it. It is also said that CFDs evolved from equity swaps. Equity swaps and CFDs are similar sense that one party is obligated to pay the return on a stock, index or portfolio and the other part is obligated to pay a fixed exchange rate or the value of another position Futures contracts Futures markets formalize and standardize forward contracting. Buyers and sellers trade in a centralized futures exchange. The exchange standardizes the types of contracts that may be traded: It establishes contract size, the acceptable grade of commodity, contract delivery dates and so forth. This differs from the way CFDs trade since futures contracts are traded on organized exchanges or auction markets and CFDs are traded through market makers. Even so CFDs share some common properties with futures contracts. Firstly an investor is able to either take long or short positions when dealing in futures contracts the same as an investor dealing CFDs. The Futures contracts are a zero-sum game, with losses and gains to all positions netting out to zero. For this reason, the establishment of a futures market in a commodity should not have major impact on prices in the spot market for that commodity. This is another similarity between furtures contracts and CFDs. Both are zero-sums games. Both futures contracts and CFDs are traded on margin. For example, at initial execution of a futures trade, each trader establishes a margin account. On any day that futures contracts trade, futures prices may rise or may fall. Instead of waiting until the maturity date for traders to realize all gains and losses, the clearinghouse requires all positions to recognize profits as they accrue daily. If a trader accrues sustained losses from daily marking to market, the margin account may fall below a critical value called the maintenance margin. A margin call is issued one this happens. In both CFDs and futures contracts profits and losses are credited or debited the margin account on a daily basis. Futures as well as CFDs are priced according to an underlying. The difference is of course that CFDs do not have a maturity date and there is no obligation to exchange whatever underlying to which the CFD is traded on. 22

23 6.4.3 Shares As CFDs are margin traded, your deposit can allow you to take a larger position than you would if you were purchasing ordinary equities, offering you a much greater return on your investment (ROI). To see the effect of gearing, here is an example of a CFD deal compared to an equity deal, where the investor uses the same amount required for a CFD deposit to buy ordinary shares instead. (Reference 4) Opening the position CFD Trade Equity trade Price of ABB stock 145 SEK 145 SEK Number of shares/contracts Value of shares/contracts SEK SEK 1 Commission 362,5 SEK 59 SEK Total value ,5 SEK SEK 2 Deposit required SEK 0 Initial cost ,5 SEK SEK Closing the position CFD Trade Share or equity trade Price of company A 148 SEK 148 SEK Number of shares/contracts Value of shares and SEK SEK contracts Commission 370 SEK 59 SEK Difference in value 3000 SEK 300 SEK Profit (difference 2267,5 SEK 182 SEK commission) 3 Percentage ROI 15,8 % 1,25 % 1. Commissions on CFD trade is based on a percentage of 0,25 % of the total value of the underlying position. This is the rate at which United Brokers at the moment charge on a CFD trade. 2. The example assumes a CFD trade on 10 % margin. 3. Percentage Return on investment; is calculated by dividing the profit from the initial cost. The example above describes the difference in trading CFDs as supposed to trading regular shares. Notable is the difference in ROI between the two trades. This is the leverage working. Notable is also the commission rate between the trades. Even though the commission on the stock trade is cheaper it still takes a lot more of the profit away from the trade. 23

24 6.4.4 Options There are two similarities between options and CFDs. The first is they both provide leverage to the trader. Secondly, both instruments allow the investor to participate in the downside of falling markets by taking a short position. Option pricing involves several elements such as prevailing interest rates, dividend expectations, the current price of the the underlying asset, its volatility and the time to expiry of the option. The fact that so many elements are brought into the pricing equation can lead to a lack of transparency in pricing and a lack of liquidity in the product. 24

25 7 Risk management This chapter will focus on how CFDs can be used to manage risk; either to decrease it or increase it. The chapter will begin by defining risk management then continuing describing two aspects of risk management. One in where the investor manages her risk with CFD trades by using different types of risk management tools. The other part will describe how an investor trading CFDs can use the derivative to manage the risk of a portfolio consisting of other financial assets. The last part of the chapter will handle hedging. 7.1 Introduction to risk management According to Bennett W. Golub and Leo M. Tilman risk management is concerned with measuring, mitigating and controlling large financial losses, that is, modelling the left tail of the future distribution of random returns. Risk management is also the practice of defining the risk level an investor desires, identifying the risk level an investor currently has, and using derivatives or other financial instruments to adjust the actual level of risk to the desired level of risk. The last definition is the one on which the focus will be on. This definition directly relate to the question in chapter five; How do private investors use CFDs to manage risk?. Derivatives have been embraced not only as tools for hedging but as means of controlling risk; that is, reducing risk when one wants to reduce risk and increase risk when one wants to increase it. 7.2 Risk management relating to CFD trades There are two types of ways to manage risk with CFDs. One is associated with the CFD trading itself and the other is associated with implementing CFD strategies to manage risk in a portfolio of other financial instruments. This part will describe various ways in which a private investor can use tools to reduce the risk when trading CFDs Limit order When using a limit order, an investor specifies a price at which he or she is willing to buy or sell a security. If for example the security falls below the limit on a limit buy order then the trade is to be executed. Correspondingly a limit-sell order instructs the broker to sell as soon as the stock price goes above the specified limit. 25

26 7.2.2 Stop-loss order Stop-loss orders are similar to limit orders in that the trade is not to be executed unless the CFD or security hits a price limit. In this case however, the stock is to be sold if its price falls below a stipulated level. As the name suggests, the order lets the stock be sold to stop further losses from accumulating. Symmetrically, stop-buy orders specify that the stock should be bought when its price rises above a given limit. Stop-loss and stop-buy orders are very important when trading CFD contracts. Because of the amount of leverage incurred when trading CFDs an investor can not afford to be without stop-loss orders in the long run since her position might move rapidly against her, leaving her with unnecessary large and possibly devastating losses One cancels the other (OCO) order According to Investopedia.com the definition of and OCO order is the following: An order stipulating that if one part of the order is executed, then the other part is automatically cancelled. This type of order is especially useful if you have, for example, bought equity CFDs and have set a stop-loss order at some level below the price of which you bought the equity for. Let s say next you want to place a limit order at some level above the price at which you bought the equity. Theoretically what can happen is that the market drops, executing the stop-loss order. At this point you have sold your position of equity CFDs, having zero equity CFDs in your account. With the limit order still in place the market could bounce back executing the limit order. Your position at this point is you will short sale the equity CFDs. This can create and awkward situation and can lead to potential losses since you are short when obviously this was not the initial plan. To avoid this problem you can create an OCO limit order linked to your initial stop-loss order. In the case described above, when the stop-loss is executed the limit order will automatically be cancelled leaving you with no orders on the market. Another useful way of using OCO orders can be the following: An investor with limited funds may place an order to buy both stocks and bonds and specify that it's a "one-cancels-the-other-order." In other words, if the market favours stocks and they are bought, the order to buy bonds will be cancelled. Conversely, if the market suggests bonds are the way to go, the order will be to buy bonds and the order to buy stocks will be cancelled. 26