Chapter 17 notes 2012 08 04

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Chapter 17 Contracts for Differences (CFDs): 

Chapter 17 Contracts for Differences (CFDs) August 2012 fin logIQ Knowledge for financial IQ STRICTLY PRIVATE AND CONFIDENTIAL

Chapter summary and outline: 

Chapter summary and outline This chapter outlines the history, features and trading mechanisms of CFDs, trading opportunities, trading strategies, governance and risks of investing in CFDs. Chapter outline: Introduction to Contracts for Difference Trading mechanisms for CFDs Global trading opportunities CFD trading strategies Risks of investing in CFDs 2

Introduction To CFDs: 

Introduction To CFDs First traded over the counter (“OTC”) in the equity swap market: Institutional investors used them as a cost effective way of hedging their equity exposures Arbitrageurs and hedge fund managers use them for market neutral strategies CFDs are effective if you have negative outlook on the market or a particular stock, without the need to borrow stock to short sell CFDs enable investors to: Take long and short equity positions Benefit from leverage With no actual change of ownership, investors get exposure to the real-time performance of underlying stock Also entitled to stock dividends and other corporate actions But CFDs investors are not entitled to voting rights Has its origin in UK and popular with investors in Belgium, Germany and Ireland CFDs are available in Australia, Hong Kong, Singapore, and South Korea but not available in the USA due to regulatory restrictions 3

What Are Contracts for Differences (CFDs): 

What Are Contracts for Differences (CFDs) They are derivative products - contract involves two parties: the buyer and the seller Buyer or seller with positive or negative view of the market, takes a position on asset price movements without the ownership of the underlying asset. Upon maturity, there is a cash settlement where seller pays the buyer the difference between the opening price and closing price of the contract Terms of a CFD: Underlying asset – it can be a stock, an index, a commodity, a currency, etc. Price of the underlying asset – at the time the contract commences Number of units of the underlying asset specified in the CFD Expiry period, if any Settlement currency 4

Characteristics and Features of CFDs: 

Characteristics and Features of CFDs Leverage Margin requirement is a fraction of the underlying asset value Flexibility Easy to take long and short positions Low cost Brokerage commissions and finance charges tend to be low and highly competitive. In Singapore, there is no stamp duty to be paid. Transparency Underlying asset is known at the outset Can be easily tracked Ease & Simplicity Investors can trade via personal broker or online CFD providers are brokerage firms Members of exchanges and have robust CFD online trading platforms 5

Characteristics and Features of CFDs - 2: 

Characteristics and Features of CFDs - 2 No expiry date Open position can be rolled over and held as long as the investor wishes Access to Asset Classes Individual stocks, market indices, government treasuries, foreign exchange, commodities and exchange-traded funds (ETFs). New asset classes e.g. carbon emissions and market volatility indices. Access to Global Investments Not limited to domestic Singapore securities Trade worldwide on various Exchanges Cash Settlement Cash settled products No delivery of an underlying instrument Corporate Actions Stock CFDs investor holding a long position will get cash dividends on the underlying stock and participate in stock splits and the other corporate actions, just as if the investor owned the physical stock. But not entitled to any voting rights 6

CFD Business Models: 

CFD Business Models Three main business models: Market-Maker Makes a market in CFDs, and Quotes its own bid-ask price Direct Market Access (DMA) Order goes through the CFD provider’s platform Investor access the market directly Price paid is determined by the market of the underlying asset Exchange-traded CFDs Traded on an exchange just listed stocks This type of CFD is not common and is currently available in Australia 7

Unique Advantages of CFDs Over Other Instruments: 

Unique Advantages of CFDs Over Other Instruments 8

Unique Advantages of CFDs Over Other Instruments: 

Unique Advantages of CFDs Over Other Instruments 9 Cont..

Trading Mechanisms of CFDs: 

Trading Mechanisms of CFDs Margin To initiate a CFD trade, investor does not have to pay the full underlying value Pays a fractional sum in cash (or initial margin) Computed as a Percentage of the overall value of the underlying asset Varies depending on the type of security, asset class, country regulations and the specific requirements of the CFD provider. Example: A CFD on Company A’s shares requires a 10% initial margin. The share price is $2 and the total value for 10,000 shares = $2 x 10,000 = $20,000. As the margin required is 10%, the investor has to put up a cash deposit of only $2,000 as the initial margin at the time of opening his position. This effectively gives the investor 10 times leverage on the invested sum. 10

Trading Mechanisms of CFDs - 2: 

Trading Mechanisms of CFDs - 2 Marked-to-Market CFD’s value varies with the price of the underlying asset in real-time. At the end of each trading day, any gain (or loss) is added to (or subtracted from) This is called “marked-to-market” Margin Call If the balance in the investor’s account falls below a stipulated level called “maintenance margin” Investor receives “Margin call” to top up the account to restore the account balance to the level of “initial margin” If unable to meet the margin call -> “liquidation” Provider must inform the investor, at establishment of CFD account about: Margin requirements, margin limits, and liquidation procedures Investors must be familiar with these procedures stated in Risk Disclosure Statement (“RDS”) 11

Trading Mechanisms of CFDs - 3: 

Trading Mechanisms of CFDs - 3 Liquidation The CFD provider may liquidate the investor’s position if account balance is below the level of the maintenance margin, and Funds to restore the margin position are not received within the stipulated time frame. Forced selling of the investor’s CFD holdings The liquidation: May be for entire CFD holdings or Partial to extend that number of contracts force sold is sufficient to cover the shortfall and have the margin level restored. The investor is liable for any shortfall, loss and expense as a result of the liquidation. 12

Trading Mechanisms of CFDs - 4: 

Trading Mechanisms of CFDs - 4 Orders and Stops Order can be placed before, during and after trading hours All orders are considered to be Good Till Cancelled (GTC) unless stated Orders: In Singapore there are 3 types of orders for equity CFDs: Limit Order: An order to transact at a limit price or better Market to Limit Order Order to buy or sell equity CFDs at the market price at the time the order is placed and executed. There is no guarantee that the quoted price at the time the order is placed will be achieved as the price may be different when the order is executed. When the order is executed, it may be filled in total or partially. If partially filled, any unfilled part will remain open in the market at the price where the previous part of the order was filled. Market Order Order to buy or sell a stock at the current market price Order will be done at the best price that the market can offer 13

Trading Mechanisms of CFDs - 5: 

Trading Mechanisms of CFDs - 5 Contingent Orders (Stop-Loss/ Stop Entry) Orders that will automatically be generated when specific market conditions are met, e.g. Stop-Loss or Stop Entry Stop Loss Order An order that is contingent upon the stop price being reached. Used by traders to cut a losing position at a price worse than the current prevailing price or protect an existing profit (Trailing Stop) once a pre-determined price is traded. Stop Entry Contingent orders to place Stop Entry orders. When exiting a short CFD position, a stop order (Buy Stop) can be used to set a stop-loss target on the position at a price higher than the current prevailing price. A long CFD investor can place a (Buy Stop) order that can be used to enter the market at a higher price than the current prevailing price. Using a stop in this instance allows entry into the market when the investor believes the share price has moved through a break out point in its trading range and will then continue to rise. The reverse applies for a Sell Stop. 14

Trading Mechanisms of CFDs - 6: 

Trading Mechanisms of CFDs - 6 Contingent Orders (cont) Use of stop loss Is a trading strategy that can mitigate some of the risks involved in trading CFDs. Allows a stop Loss price at which the open position will be automatically closed out If the underlying asset on which the investor is trading reaches a certain price, the position will be closed out. Use of this strategy can be risky Even if a stop-loss price has been set, the CFD provider may not always execute the stop-loss order at the price that has been set May happen in volatile market conditions - price jumps and there is no transaction taking place at the set order price Some providers offer additional premium service called “guaranteed stop-loss” whereby the stop loss will always be executed when the underlying asset reaches your set price. Order validity Good till cancelled (“GTC”) – order must be manually cancelled End of Day (EOD) – order only valid on the day it is placed 15

Financing: 

Financing CFDs are subject to other transaction costs such as daily financing charges, commissions and Goods and Service Tax (“GST”). Also a charge whenever there is a rollover of a contract. Financing Charge Investors incur a financing cost (derive a benefit) for either long or short CFD position As CFD requires a margin payment which is only a fraction of the total capital outlay, investors are essentially borrowing to enjoy the exposure of going long in the underlying shares. Interest charges (reflect the cost of borrowing) and usually applied at an agreed rate based on some interest rate benchmark, computed on a daily bases and charged for the number of days the position is kept open For short position, may receive interest in lieu of the deferring sale proceeds In addition provider may charge interest in view of the borrowing costs incurred in allowing the ‘short’ transactions 16

Financing - 2: 

Financing - 2 Commission Dealer firms charge commission for the CFD transactions, which is usually a percentage of the total value of the underlying asset, subject to a minimum sum. GST Commission charged by the dealer firm is subject to GST Rollover of Contract and Rollover Charges CFDs have an Expiry date which is determined by the CFD provider Upon expiry, the investor can continue to maintain his position by trolling over the contract 17

Financing - 3: 

Financing - 3 Example: CFD Costs An investor buys a CFD contract on Company F. The price of the share on opening day is $2.00. After 10 days, the stock price rises to $2.20. What are the total expenses incurred and net profit? Company : Company A Quantity : 10,000 Commission = 0.4% GST (Commission) = 7% Financing = 5% per annum 18

Financing - 4: 

Financing - 4 Example: CFD Costs 19

Going Short : 

Going Short Example 1: An investor shorts a CFD contract on Company G. The price of the share on opening day is $3.30. After 5 days, the stock price falls to $3.10. The margin requirement for the stock is 20%. What are the net profit and investment returns (ROI)? Quantity : 10,000 Commission = 0.40% Margin requirement = 20% GST (Commission) = 7% Financing = 6% per annum 20

Going Short - 2 : 

Going Short - 2 Example 1 (cont): Profitable (Positive) Outcome 21

Going Short - 3: 

Going Short - 3 Example 2: An investor shorts a CFD contract on Company H. The price of the share on opening day is $3.30. After 5 days, the stock price rises to $3.45. The margin requirement for the stock is 20%. What are the net profit and investment returns (ROI)? Quantity : 10,000 Commission = 0.40% Margin requirement = 20% GST (Commission) = 7% Financing = 6% per annum 22

Going Short - 4 : 

Going Short - 4 23 Example 2 (cont): Loss (Negative) Outcome

Corporate Actions & Rights Issue: 

Corporate Actions & Rights Issue Corporate Actions – Cash Dividends Dividends will be credited or debited based on the investor’s CFD position. Investors with long positions in Stock CFDs will receive a dividend credit while those with short positions will have the amount debited from their account. Corporate Actions – Stock Splits, and Reverse Splits The quantity and price adjustment will be made in the investor’s account to reflect the market equivalent. Corporate Actions – Scrip Dividends, Bonus Issues, Right Issues The CFD investor may or may not be entitled to them. For bonus issues, non-cash dividends and rights, the client may not receive these entitlements and the CFD provider may close off all open positions before the ex-date. 24

Comparison to Trading Futures: 

Comparison to Trading Futures 25

Global Trading Opportunities: 

Global Trading Opportunities Trading Share CFDs Trading Index & Sector CFDs Currencies Commodities Government Treasuries Exchange-Traded Funds (“ETFs”) Others –new indices such as Carbon Emissions and Market Volatility (VIX) 26

CFD Trading Strategies: 

CFD Trading Strategies Trading for Dividend (Dividend Stripping / Dividend Capture) Long position in a stock CFD gives investors benefit of receiving dividends declared by the company. Conversely investor who has a short position has to pay out the amount of dividend declared. Can profit from good yielding stocks by timing the trade of the stock CFD When the stock goes ex-div, its price is theoretically supposed to fall by the divd . amount and there is no net difference in the total value to the shareholder. However, the stock price does not always behave this way. When sentiment is positive or the stock is rising due to positive momentum, the stock price does not fall by the full amount of the divd . and may even get back to its pre- divd level quickly. A CFD trader can exploit such market anomalies and make a tidy profit by capturing the stock dividend. He buys the CFD before the ex-div date and closes his position shortly thereafter, before the share price has fully adjusted to the theoretical ex-div price. Look out for companies that have good dividend payouts and monitor them to select the right stocks that offer opportunities for a divd . stripping opportunity 27

CFD Trading Strategies - 2: 

CFD Trading Strategies - 2 Trading in Pairs CFDs pairs trading involves taking two CFD positions - 1 long and 1 short Objective of this strategy is to exploit a perceived deviation in the underlying share prices from historical trends and the likelihood of price reversion to the normal trend in the near future Strategy is “market-neutral” as direction of the overall market should not affect the investment position’s overall outcome Aims to remove the market risk as the long and short positions will neutralize each other not necessary for each position to yield a profit as the result will be positive even if only one is profitable and exceeds a potential loss on the other the investor’s gain is based primarily on stock selection as overall outperformance depends on the returns on the long position (undervalued) over the short position (overvalued) 28

CFD Trading Strategies - 3: 

CFD Trading Strategies - 3 Trading in Pairs (cont..) Strategy is not without risk or costs Sometimes, the anomalies between the overvalued and undervalued underlying stock may persist for long periods without converging and the investor may not realize his arbitrage profits quickly The markets may move against the investor and one or both sides of the pairs trade may move the wrong way As a result, the loss may overwhelm the profitable leg of the trade and leave the investor with a negative return overall Since investor taking two positions – one long and one short, trade will involve double commissions and finance charges 29

CFD Trading Strategies - 4: 

CFD Trading Strategies - 4 Trading in Pairs (cont..) Many strategies and variations possible for trading equity pairs: Industry Sector Plays A play on two companies in the same sector, one that is undervalued or has a positive outlook (long position) and the other is overvalued or has a pessimistic outlook (short position). Statistical Arbitrage Based on quantitative analysis Two companies that have a strong historical correlation and price pattern but recent short-term market movements indicate a deviation from the trend Investors believes there will be a “mean reversion” and pattern reverts to norm. Merger Arbitrage After a merger announcement, a trader can Go long the target company if he expects further upside price movement Go short in the acquirer’s stock. Main risk – “deal risk” Risk that the announced deal may fail and not be completed Investor facing potential loss on both the long and short legs 30

CFD Trading Strategies - 5: 

CFD Trading Strategies - 5 Trading in Pairs (cont..) Equities Indices Select individual stocks for pairs trading (risky if stocks are illiquid) Alternatively, use equity indices as they can be easier to monitor for trends and movements while offering deeper liquidity to the trader Commodities Same commodities class ( ie Brent vs WTI or gold vs silver) Process chain of a commodity – “crack spreads” (unrefined vs refined products) Maturity dates for the same commodity ( ie “calendar spreads”) Involves forecasting demand or supply shifts by trading different expiration dates Global macro strategies (based on econ growth, inflation, weather trends) Fixed Income Trading government bonds Interest Rate Differentials Capital seeks the highest return and “carry” traders look for the most appealing yield differential where they borrow in one country and invest in another country 31

Risks of Investing in CFDs: 

Risks of Investing in CFDs Leverage Risk CFDs are leveraged product as it is traded on margin Initial margin is percentage of the contract value Small changes in the underlying asset can have significant impact on trading returns as gains/losses on a leveraged product are magnified Daily marking-to market and margin calls May demand that the investor put up more money at short notice If the investor is unable to meet the margin call, the position may be forced sold Market Volatility (Underlying Instrument) Investors may take long/short CFD position - intention of making a profit when the price of the asset rises/falls Closing a CFD position while the underlying asset is subject to a corporate action may result in delays to the investor receiving any proceeds or a credit entry to his account or even the possibility of not being able to get any price quotes to close out positions. Smaller international markets may have lower trading volumes – increases risk that the liquidity of the CFD maybe poor 32

Risks of Investing in CFDs - 2: 

Risks of Investing in CFDs - 2 CFD Model Risk (Direct Market Access vs. Market-Maker) Market maker model Liquidity and efficient pricing depends CFD provider’s ability to make a market by ensuring adequate supply to meet investor demand keep a tight bid-ask spread so that investors trade in a cost efficient manner Discretion on the bid-ask spread lies with the CFD provider and is not transparent to investors. Direct Market Access (“DMA”) model: pricing is transparent as the CFD trade is based on the underlying assets’ market price which is directly observable Buy-Sell order goes through the CFD provider’s platform Investor gets access to the market directly in which the price paid is determined by the underlying market. Exchange-traded CFDs are transacted on a stock exchange Orders are placed through stock brokers who have access to the exchange. Fully transparent to the investor 33

Risks of Investing in CFDs - 3: 

Risks of Investing in CFDs - 3 Counterparty Risk Present when dealing with another entity (counterparty) in a transaction When buying or selling a CFD CFD provider becomes the counterparty If CFD provider is unable or unwilling to meet his contractual obligation, due to financial or other difficulties, this can have an impact on the investor Exception: exchange-traded CFDs Liquidity Risks If not enough trades made in market for an underlying asset (due to lack of liquidity, or trading may be halted or suspended) CFD provider may either decline to fill the investor’s trades, or only agree to process the trade at an inferior price, which may leave the investor with an open CFD position that he is unable to close. E.g. Periods of high market volatility or low turnover when it may be difficult or even impossible to buy or sell (close out) existing positions. For international assets: Changes in the economic, political and regulatory environments in a country or region can cause demand and supply of an underlying to rise or fall suddenly, making CFDs more volatile 34

Risks of Investing in CFDs - 4: 

Risks of Investing in CFDs - 4 Currency Risks Transactions in foreign currency-denominated instrument different from the investor’s base currency gives rise to foreign exchange risk Financing Cost Investor must take into account all related costs involved: brokerage commissions, account maintenance fees and financing costs. CFD provider will charge the investor interest for providing him with financing. Interest to be charged on the full amount of the value of the CFD position, computed on a daily basis, based on a spread over LIBOR or another market benchmark, as disclosed and agreed to between the CFD provider and investor. Client is exposed to interest rates movements. If the interest rates rise, the financing cost for the CFD investor goes up. This raises the total holding cost of his investment position and erodes the eventual investment returns. 35