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Education

Financial Instruments and Engineering

Cash or derivatives

  • Single name or basket of names/indices
  • Exchange traded or OTC traded
  • Cash: equities, FX, fixed income, credit, energy, commodities, etc.
  • Derivatives based on: equities, FX, fixed income, energy, commodities, baskets, indices, credit, e.g. futures, forwards, options, CFDs, CDOs, IRS, CCS, CDS, etc.

Cash Markets

  • Also called spot markets or physical markets.
  • Traded instruments are settled normally within a couple of business days, e.g. international bonds two days after the trade (t+2).
  • Notional amount is fully paid.
  • Where applicable the owner holds all rights of the underlying, e.g. proxy voting rights for stocks.

Other Categorization

  • Single names: equities, FX, fixed income, credit, energy, commodities, etc.
  • Basket of names/indices: country baskets, industry baskets, currency baskets, stock indices, commodity indices, etc.
  • Exchange traded: listed stocks, fixed income, futures, options, commodities, etc.
  • OTC traded: listed and unlisted stocks, fixed income, forwards, OTC options, FX, IRS, CCS, CFDs, CDOs, etc.

Exchange Traded Products

  • An exchange sets specific rules.
  • Cash and derivative products can be traded on an exchange.

Key technical characteristics of exchange traded products are

  • Products are specified in detail, i.e. no ambiguity regarding asset or underlying, price, notional amount or settlement.
  • Contracts are homogenous, e.g. standardized contract size, underlying, method of delivery, expiry dates.
  • “Investors know exactly what they buy and sell and prices are transparent.”
  • No counterparty credit risk but trading on an exchange can be expensive (margins, membership etc).
  • Effectively no counterparty risk.
  • Listed companies on a stock exchange must fulfill certain standards like disclosure of audited financial figures, relatively high liquidity margin, minimum capitalization or trading volume etc.
  • The exchange demands that people who deal with the exchange are qualified. For this purpose the exchange requires them, for example to take and pass exams set/specified by the exchange.

Over-the-Counter (OTC) Traded Products

  • OTC transactions could be defined as an agreement/contract directly between two parties to trade without going through an exchange or other intermediary.
  • As trading counterparts deal directly with each other they must rely on each other’s credit quality and integrity.
  • Unlike exchange traded products the size, maturity, delivery date or settlement method can be customized, e.g. whereas FX futures are standardized, the specification of FX forwards are according to the agreement of the two parties.
  • OTC transactions carry counterparty credit risk.
  • The reference asset of an OTC transaction is normally listed on an exchange (enhances transparency and minimizes ambiguity) but this is not a prerequisite.

Examples are:

  • OTC agreement/contract between two parties on single name equity, bond, commodity, energy, etc. – both cash and derivatives.
  • OTC transactions were the reference asset(s) (or some of the reference assets) is not listed at an exchange, e.g. credit derivatives, baskets, FX spot etc.
  • OTC transactions on the price of a used Toyota car one year from now.

Futures and Forwards

  • Futures are traded at a future exchange like NYMEX and are standardized regarding notional amount, underlying, price, and maturity/settlement date.
  • Forwards are a typical OTC product where the two parties can freely agree on any notional amount, underlying, price, and maturity/settlement date.

Contracts for Difference (CFD)

What is a CFD?

A Contract for Difference (CFD) is an over the counter derivative contract under which two parties agree to exchange the difference between the opening and the closing value of the contract, with reference to a specific underlying. CFDs can be traded on different underlying financial instruments. The most popular and common CFDs are:

  • Forex such as EURUSD, EURGBP, USDGBP
  • Precious metals such as Gold and Silver
  • Energy products such as Crude Oil and Gas
  • Futures on Indices such as S&P 500, Dow Jones, NASDAQ
  • Currency Futures such as EC (EUR), BP (GBP), JP (JPY)

Numerical example – CFD on EUR/USD

  • The client decides to go long in euro against the dollar and so buys 5 contracts (€500,000 – each lot is €100,000) at 1.4827, that is $741,350. Assuming a deposit of 1% the cost is:
  • $(500,000 X 1.4827 X 0.01) = $7,413.5
  • 3 weeks later the dollar has fallen against the euro and the client decides to take the gain at the bid price of 1.4927, thus his contracts are now worth:
  • $(500,000 X 1.4927) = $746,350
  • The client makes therefore a gain of $5,000 – net of commission (5 x $50 – $250) is equal to $4,750. This is a return of 64%.

Numerical example – Crude Oil CFD

  • Oil trades at $91 a barrel and the client believes it will rise so he decides to buy 2,000 barrels as a CFD at the offer price of $91.
  • The lot size is defined as 1,000 barrels so this will be 2 lots. Each lot is therefore priced at $91 x 1,000 = $91,000.
  • The total notional size of the contract is equivalent to: 91 x 1,000 X 2 that is $182,000. Because the position is leveraged the client needs only $1,820 (assuming 1% margin).
  • One week later the price of oil has risen to $94 per barrel and the client decides to take his profit and close the contract. The current value of which is given by 94 x 1,000 that is $188,000. The client’s profit is therefore $6,000 – a return of 330%.

How to compare CFDs, Futures and Forwards

 

Alpha Capital CFDs