What is a CFD

In simple terms 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, with reference to the underlying share. This amount is then multiplied by the number of shares specified within the contract.

It is estimated that up to 20% of UK equity market turnover is based on paper contracts as opposed to the actual transfer of shares. There are always two parties to a CFD: the long party and the short party. If the client opens the contract by buying the CFD he is the long party and if the CFD is opened with a sale, the client becomes the short party.

A CFD has a contract value - defined as the number of shares in the contract multiplied by the price of the underlying reference share. The long party will gain if the value of the CFD increases. Conversely, the short party will benefit if the contract value falls. A long CFD, though it replicates the physical underlying reference share in terms of monetary return (including dividends), does not give the holder rights to acquire the underlying share and therefore confers no shareholder rights. A short CFD gives the holder all the benefits of a fall in the value of the shares, but at no point will there be a requirement to deliver the underlying shares.

Holders of the long or short CFD do not pay the full underlying value of the contract. Instead they are required to deposit funds (known as margin) as collateral. Margin is calculated as a percentage of the contract value, and as CFD prices change on a frequent basis, the client is responsible for maintaining the agreed margin rate of the contract value plus any loss as a result of re-evaluation.

Clients pay interest daily on the value of the long CFD since the CFD provider has effectively financed the value of the trade and charges a spread over LIBOR for this service (typically 3%). So, hypothetically, if base rates were at 5.75%, the client would pay 8.75% on the 80% (typically) of the value of the trade that the CFD provider has funded on the client's behalf. Similarly, the client receives interest on short CFD positions, typically at an annualised rate of 3% below base rates. So, established short CFD positions attract an interest credit (using our hypothetical base rate of 5.75%) of (5.75-3.00) = 2.75% annualised, which is credited to the account on a daily basis.