11 - Contract for Difference

Objective Questions

1. The striking difference on comparing CFD and futures is
a. CFDs have no expiry date.
b. CFDs are derivative contracts.
c. CFDs are of a speculative nature.
d. All of the above.

2. With CFDs, the investor can take
a. A long position.
b. A short position.
c. Either a long or a short position.
d. None of the above.

3. The commission on a CFD is calculated as a percentage based on
a. Performance of the underlying asset.
b. Performance of the market.
c. Value of the contract.
d. All of the above.

4. Interest on clear margin is paid to the investor based on
a. A percentage of the value of trade.
b. A preagreed rate of interest.
c. A percentage against marked-to-market calculated on daily basis.
d. None of the above.

5. The initial margin requirement varies upon
a. The contract between the buyer and seller.
b. The stock market concerned.
c. The underlying asset.
d. All of the above.

6. Settlement for CFDs happens through
a. Physical settlement of securities.
b. Cash.
c. Both cash and physical settlement of securities.
d. None of the above.

7. CFDs are traded
a. Over the counter.
b. On exchanges.
c. Both over the counter and on exchanges.
d. None of the above.

8. Funding costs are calculated based on
a. Average market price of the underlying asset.
b. Agreed percentage on the closing market value.
c. Agreed percentage on the opening market value.
d. None of the above.

9. For short positions in CFD contracts, the funding cost will be received by the
a. Investor.
b. Stock exchange.
c. Seller.
d. None of the above.

10. For long positions in CFD contracts, the funding cost will be received by the
a. Investor.
b. Stock exchange.
c. Seller.
d. None of the above.

11. CFDs are open-ended contracts with no fixed end date. So the investor of a long position can keep extending the contract by
a. Paying a fixed amount at end of every month.
b. Receiving interest based on an interest rate benchmark till he holds the position.
c. Paying interest towards over-night/financing charges based on an interest rate benchmark.
d. Carrying forward the position at no cost.
e. Paying a deposit amount agreed upon with the seller.

12. In CFD markets, though an investor does not own a share literally, he is still entitled to
a. Voting rights.
b. Participate in the annual shareholders meeting.
c. Receive trading recommendations from the exchange.
d. The benefits of corporate actions like dividends.
e. All of the above.

13. Which of the following are the advantages of CFDs?
a. Transparent pricing.
b. No expiry period.
c. Receive dividends on bought open positions.
d. Receive interest on sold open positions.
e. All the above.

14. When an investor buys a long CFD with a contract size of 1,000 at $90 per share and the margin deposit required to be paid is 10 percent, then what is the leverage amount that is being financed to the investor?
a. $90,000.
b. $9,000.
c. $99,000.
d. $81,000.
e. $8,100.

15. The following journal entry is passed when
Journal Entry
Date               Particulars                                                         Debit (US$)                Credit (US$)
1-Oct-X1      CFD Funding Cost Account                                    60.00
To CFD Margin Account                                                                          60.00
(Being the funding cost to carry over the long

position of CFD in respect to shares bought.)
a. The buyer of the CFD contract is financed with the leverage amount.
b. The interest is paid towards the overnight open position.
c. The seller of the CFD contract is financed with the leverage amount.
d. The interest for the overnight position is received.
e. The buyer of the CFD contract pays the margin amount.

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Theory Questions

1. Define a CFD contract and explain how it is different from a futures contract.

2. What are the salient product features of CFD?

3. Is short-selling possible with CFDs, and if so are there any advantages?

4. How is the funding cost computed for a CFD contract?

5. What are the margin requirements for a CFD contract?

6. Discuss briefly the advantages and disadvantages of a CFD contract.

7. “CFD is highly risky.” Do you agree? Give reasons for your answer.

8. How is a CFD contract terminated?

9. Explain the trade life cycle for a CFD contract and what journal entries are passed for each event in the cycle.

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• A contract for difference is a contract between two parties, buyer and seller, stipulating that the seller will pay to the buyer the difference between the current value of an underlying equity share and its value at contract time.
• However, if the difference is negative, then the buyer pays to the seller such difference. A CFD is an equity derivative contract that allows the inves-tor to speculate on share price movements, without the need to own the underlying shares.
• A contract for difference offers all the benefits of share trading without having to physically own tshares. A CFD is ideal for short-term technical trading and hedging positions in the underlying market.
• An investor can sell a CFD as an opening position, since a CFD is a contract between the investor and the CFD provider, based upon the price movement of the share.
• An investor may be able to profit from a falling market using this instrument of CFD.
• The investor having a long position is required to pay a daily financing charge applied at an agreed interest rate above or below LIBOR or some other interest rate benchmark, while an investor holding a short position receives such interest.
• Clear margin is the investor margin account adjusted for all positions marked-to-market, less initial margin requirements for all open positions.
• Interest is normally paid to the investor on such clear margin at a preagreed rate of interest.
• Investors in CFDs are required to maintain a certain amount of margin as defined by the counter party or market maker, which could range from 10 to 30 percent.
• The amount required to be held in the margin account will be as per the terms and conditions imposed by the market maker or counterparty.
• CFDs offer several advantages, like transparent pricing, effective use of capital, increased trading flexibility, access to international markets, stamp duty exemption in some markets, receipt of dividends on bought open positions, receipt of interest on sold open positions, the ability to go short, high leverage, and so on.
• However, CFDs suffer from increased trading risk due to the high leverage that it inherently offers to the investors. CFDs are not suitable for long-term investment and there are no voting rights for a person who is long in CFDs, unlike an investor holding traditional shares.
• CFDs do not have an expiry date. They remain open until they are closed in accordance with the terms of the client agreement.

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