Understanding What Contracts For Difference Are.

1. Understanding Contracts For Difference
[CFD's]
Christopher M. Quigley, B.Sc., M.M.I.I., M.A., WealthBuilder.ie |
April 7, 2008
ONE of the most innovative financial instruments that has been developed over the last decade
or so is the CONTRACT FOR DIFFENCE, better know as a CFD. The explosion in the use of
this product is one of the reasons why London, as opposed to New York, is becoming the
financial location of preference for many financial managers and hedge traders. CFD's are not
allowed in the U.S. due to legal restrictions imposed by the American Regulators.
Contracts For Difference were developed in London in the early 1990's. The innovation is
accredited to Mr. Brian Keelan and Mr. Jon Wood of UBS Warburg. They were then initially
used by institutional investors and hedge funds to limit their exposure to volatility on the London
Stock Exchange in a cost-effective way, for in addition to being traded on margin, they helped
avoid stamp duty (a government tax on purchase and sale of securities).
A CFD is in essence a contract between two parties agreeing that the buyer will be paid by the
seller the difference between the contract value of the underlying equity and its value at time of
contract. This means that traders and investors can participate in the gains and losses (if shorting)
of the market for a fraction of capital exposed if the equity was purchased outright. In This
regard the CDS's operate like option contracts, but unlike calls and puts, there are no fixed
expiration dates and contract amounts. However contract values are normally subject to interest
and commission charges. For this reason they are not really suitable to investors with a long-term
buy and hold strategies.
CFd's allow traders to invest long or short using margin. This fixed margin is usually about 5-
10% of the value of the underlying financial instrument. Once the contract is purchased there is a
variable adjustment in the value of the clients account based on the "marked to market" valuation
process that happens in real time when the market is open. Thus for example if a stock ABC Inc.
is trading at $100 it would cost approx. $10 to trade a CFD in ABC. If 1000 units were traded
it would therefore cost the investor $10,000 to "control" $100,000 worth or stock. If the stock
increased in value to $110 the "marked to market" process would add $10,000 to the clients
account (110-100 by 1000). As we can see the situation works very similarly to options but for
the fact that there are no standard option contract sizes and expiration dates and complicated
strike levels. Their simplicity has added greatly to their popular appeal amount the retail public.
Contracts For Difference are currently available in over the counter markets in Sweden, Spain,
France, Canada, New Zealand, Australia, South Africa, Australia, Singapore, Switzerland, Italy,
Germany and the United Kingdom. Their power and scope continue to grow. This development

2. poses a problem to American financial institutions in that unless there is a change in security
regulation Wall Street will lose out on a financial instrument that is changing the manner in
which the greater public and aggressive financial managers are investing for the future. It is
expected that Contracts For Difference will become the medium of transaction for the majority
of World traders within the next decade.
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