Stocks - Contracts for Difference
In his book Accounting for Investments, Equities and Options R. Venkata Subramani states that
“A contract for Difference (CFD) 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 expiry date or on date of termination. 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 investor to speculate on share price movements, without the need to own the underlying shares. In a contract for difference, an investor can take a long or short position. Unlike future contracts, CFDs have no fixed expiry date or contract size. The parties to the trade determine the expiry date as well as the contract size for the trade. Parties to the trade are required to maintain margins on their positions, typically 10 to 30 percent of the notional value of the underlying asset.”
Contract of Differences, CFD henceforth, have certain characteristics. They are:
- An investor can take a CFD position without paying in full for the underlying asset.
- The profits made on CFD are larger than shares since one does not have to invest the full value of the underlying asset. This holds true for losses as well.
- CFDs are ideal instruments for short-term technical trading and hedging.
- Equity stocks, exchange traded funds or ETFs and indexes can be traded in CFDs. The markets where CFDs can be used include USA, Hong Kong, Tokyo and the United Kingdom.
- No restrictions on going long or short.
- Automatic rollover if the position is not closed at the end of the day.
- The investor is entitled to receive the dividends of the shares of the company she holds, despite not owning it, through the seller of the CFD.
- No voting rights in the company whose share the investor holds.
- CFDs have a commission charge – a percentage of the contract value for each trade.
- Margin requirements on CFD contracts indexes are lesser than that on shares.
- If a CFD contract position is to be kept open then an additional margin is required.
- CFDs are open contracts and both parties can choose to keep it open by paying the required cost.
- CFDs are settled in cash with no physical settlements of the contracts. The profit or loss is remitted to the investor.
The Opening and Closing of a CFD
- Purchase CFD
- Pay commission on the buy position
- Pay margin money on for CFD (share, ETF or index)
- Pay/receive funding cost for the long position
- Receive/pay interest money on margin money
- At the end of reporting period, decide on the fair value
- Margin call
- End the CFD
- CFD expires
- Determine profit/loss on the sale
- Determine profit/loss on ending of CFD
- Determine profit/loss on expiry
- Receive margin money and consideration
- Make *FX revaluation entries
- Make *FX translation entries
*Notes about FX revaluation and translation entries
FX Revaluation: Entries of the trade are recorded in the respective currency. If the respective currency differs from the trade currency, then each entry must be reentered in the functional currency by converting the entries at that day's FX rates. For each trade entry of each currency journal entries, income statement, balance sheet, and ledger postings must be maintained. All trade entries must then be revalued in the functional currency and a separate set of books must be maintained for the same.
FX Translation: An entry to adjust currency gains and losses due to FX rate fluctuations between the date of original entry recording and the reporting date is made; this is only for asset and liability accounts. FX translations are of two types. They are the Consummated FX translation entries and Transient FX translation entries.
Investors using Contracts for Difference or CFDs are making almost identical decisions to those using ordinary shares in a company. CFDs are meant to mirror the performance of the underlying share price whether it goes up or down.