Interest and Financing Charges


Q.: How is interest charged or credited?

A: CFD positions held overnight are subject to overnight financing. Interest is calculated and charged on a daily basis on the contract value. However, for a short contract for difference position, a conventional share sale is simulated so interest calculated on a daily basis will be earned rather than paid. The rate is usually calculated at a margin above (for long CFDs) or below (for short CFDs) the Reserve Bank's interbank overnight cash rate plus/minus 2 to 3 per cent.

 

How is Financing Calculated

With CFDs an interest premium is charged on long positions held overnight. For short positions, the interest is paid to you. The interest payment is usually based on a reference rate plus 2 to 3% (if long) or minus 2 to 3% (if short). The reference interest rate is usually a major bank's overnight lending rate.

Financing is calculated by taking the overall position size, and multiplying it by (LIBOR + say 2%) and then dividing by 365 x the amount of days the position is open. For instance, the interest rate applicable for overnight long positions may be 6% or 0.06. To calculate how much it would cost you to hold a long position for X number of days you would need to make this 'pro rata' meaning that you would need to divide the 0.06 by 365 and multiply it by X days and then multiply this by the trade size. So for example, for a trade size of $20,000, held for 30 days, the interest cost would be about $98.6. It is important to note that due to financing, long positions held for extended periods can reduce returns.

Q.: What is LIBOR?

A: LIBOR stands for the London Inter-Bank Offered Rate. This is basically the figure used when London banks lend between themselves and is usually similar to the Bank of England base-rate. LIBOR is also used to calculate the interest on overnight CFD financing.

Q.: Why am I charged a financing charge for holding a position overnight?

A: An overnight fee is applicable when holding long CFD positions overnight as then the deal is considered an investment where the broker has lent you money to buy it and is one way a CFD provider makes money from deals.

So if you hold a long position overnight you will be charged a financing charge by your CFD provider. The financing interest charge is computed by multiplying the number of CFD positions by the closing price of the market and then further by the financing charge divided by 365 days to convert this to a daily charge.

For instance, what will be the daily interest charge where the investment over which you have acquired some CFDs is worth $20,000?

Financing is worked out as follows:
  1. Check out the closing price of the investment on which you hold CFDs say $20,000.
  2. Compute the financing charge by adding the provider's premium (usually 2.5%) to Libor or RBA cash (say 2 per cent); total in this case would be 4.5 per cent.
  3. Multiply the investment amount by the financing charge: $20,000 x 4.5% = $900.
  4. Now dividing this by 365 returns $2.47 which is how much you stand to pay for 'rolling' the contract over to another day.
Financing charges on long positions are computed and charged on a daily basis and the charge will fluctuate in par with the value of the investment. So for instance if the investment value increases to $22,000, the overnight financing fee will be $2.71.

Q.: I still can't understand why there a charge to hold the position open when I have paid a commission?

A: Financing is usually only applicable for long positions. You have to pay a financing charge for positions held overnight as CFDs are a margined product. You are in effect depositing only a small fraction of the overall market value of the trade (say 10%), which allows you to hold much bigger positions than if you were buying the shares outright. So for instance, just £1000 would be needed to buy a contracts for difference representing £10,000 worth of blue-chip shares. You are effectively 'borrowing' the £9000 difference, hence the financing charges.

Q.: But doesn't the fact that interest is charged make CFDs only useful for short term investments?

A: Well, yes and no! If holding for the longer term (6 months plus) it certainly makes make sense to buy the shares outright but for shorter time-frames it makes financial sense to use CFDs. In fact, it is estimated that in the UK, with the current very low LIBOR rates, a holder can actually keep a CFD for some 6 months before the financing charges add up to offset any savings on stamp duty and broker commissions. Besides, if you buy a CFD position using, say 5X leverage and deposit the rest of the monies in a high interest bank account, then that will also contribute to offset the interest payments on your contracts for difference positions. Of course, this is just an example and there are lots of other things you could do with the money - each one having a different risk/return profile. Lastly, the fact that CFDs provide gearing means that you can take advantage of trading opportunities that wouldn't be open to you without having some serious $$$. So with a product that's ten-times geared an individual with £1,000 could potentially take a position worth £10,000.

Q.: Will IG Markets (or other providers) charge interest on a long trade even if I'm not leveraged?

A: Yes, IG Markets (or other providers for that matter) will charge you financing interest as soon as you open a trade. If you want to use 100% cash and prefer to trade long term, then don't use CFDs but use a normal brokerage account instead. Note that no interest is charged for intraday trading. Financing interest on long positions is one way CFD providers make money.

Q.: The interest is not charged on the amount of funds that you actually borrow to make up the full value but on the full face value of your open positions based on the closing price...

A: Yes, that's right the CFD interest is always based on the full trade size, regardless of margin. So if you open a CFD position with 100% margin for, say, $20,000 and you have $25,000 cash in your CFD trading account the provider will charge you interest on the $20,000. What's more, the interest paid grows as your position grows. The financing is calculated on a daily basis and is not based on the 'amount you've borrowed' when you open a position. This is one of the major differences between CFD and margin lending.


Recommend this on Google

The content of this site is copyright 2015 Contracts for Difference Ltd. Please contact us if you wish to reproduce any of it