Sunday Business Post - March 20th 2005 by Pat Kilduff

If you were a Private Client who invested in Elan you are probably feeling a little sore as a result of the dramatic fall in its share price. However, if you are an investor who doesn't hold Elan you are possibly intrigued by the mention of Contract For Differences (CFD) in describing how some private clients lost money arising from the difficulties of the Tysabri drug.

A CFD is a contract between two parties to exchange the difference between the opening and closing price of an underlying instrument at the end of the lifetime of the contract. (A CFD covers many asset classes but for simplicity of explanation we will use the example of an equity CFD). A CFD can be bought or sold and it allows an investor to leverage their initial investment. For example, a client who wished to buy 1,000 shares of Bank of Ireland on a CFD basis at €13 may initially only need to deposit 0% of the cost of that investment i.e. €1,300. This deposit is known as the margin deposit. The margin deposit can vary from between 5% - 30% of the total cost of investment depending on the volatility of the stock, the credit rating of the investor and the volatility of the market. The typical commission charged for a CFD is .25%.

CFDs also allow investors to 'short' a particular asset. Shorting describes a transaction where the investor sells the asset in the potential of benefiting from a decline in its price and offers the investor the opportunity to purchase the asset at a cheaper price at some future date. Investors can short a stock by selling a CFD hence, CFDs allow the investor to profit from a movement upwards and downwards in the price of the asset. This of course makes the important assumption that the movement in the share price is in the direction anticipated by the investor.

Another benefit of CFD's, particularly for Irish investors investing in Irish or UK equities is the elimination of stamp duty as there is no physical stock transaction. No stamp duty is applicable under current legislation which may be important to those investors who trade for a small margin on a short term basis.

Some of the less transparent characteristics of CFDs ensure that they are a product that is best used on a short term basis. A holder of a CFD pays or receives interest on the value of the contract depending on whether they bought or sold the CFD. This interest charge fluctuates but typically it will be a fixed Euribor or Libor rate minus a small margin charged by the broker. If an investor holds a short CFD they will receive Euribor or Libor interest minus a small charge by the broker. If the investor holds a long CFD they will be charged a Euribor or Libor rate because the broker has effectively financed the value of the trade. Hence as the investment time frame grows the cost associated with the investment will grow.

It is important to note that the holder of a CFD has no shareholder voting rights and if holding a short CFD position they will not receive the dividend associated with the stock.

The margin deposited for CFDs can vary and the value and the position of this margin is evaluated on a daily basis. It was this valuation of the Elan CFD that communicated to Irish private clients that margins had been breached and that subsequent positions had to be closed off or funded. The headlines in the national papers seemed to indicate that retail investors had taken a long CFD position in Elan. Based on the risks associated with Elan buying a CFD in a company where most of the value is centred around one drug is questionable at best.

Equities, despite being in the long term the best returning asset, can be extremely volatile in the short term. Hence, CFDs are only suitable to those investors who believe they have the ability to ascertain short term trading movements. The number of attractive short term positions is becoming ever smaller with the combination of hedge funds, traditional institutional investors and now private clients having the ability to act on similar investment ideas via CFDs.

As always the basic rule of investment applies - with higher anticipated rewards comes higher risk. CFDs are not for the unsophisticated investor and potential investors should be made fully aware of the risks and costs involved. Because profits and losses are based on the value of the full transaction they can be materially larger than the initial margin required to initiate the trade. At the very least stop losses and limit orders should be considered by the investor.

Pat Kilduff is Investment Manager with Appian Asset Management