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Contract for Difference Research Team | Posted On Wednesday, April 15,2009, 11:12 AM

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Contract for Difference



What is contract for difference?

A contract for difference (CFD) is a two different ways of hedge or swap contract that allows the seller and purchaser to fix the price of a volatile commodity. For case in point, consider a deal between an electricity producer and an electricity retailer who both trade all the way through an electricity market pool. If both the producer and the retailer agree to a strike price of $50 per MW/h, for 1 MW/h in a trading period, and if the actual pool price is $70, then the producer gets $70 from the pool but has to rebate $20 (whish is the "difference" between the strike price and the pool price) to the retailer. On the contrary, the retailer pays the difference to the producer if the pool price is lower than the agreed upon contractual strike price.

In consequence, the pool volatility is nullified and the parties pay and receive $50 per MW/h. Nevertheless, the party who pays the difference is "out of the money" because without the hedge they would have received the advantage of the pool price.

Futures hedging

If you principally trade in futures, you hedge your futures adjacent to synthetic futures. A synthetic in this type of case is a synthetic future comprising a call and a put position. Long synthetic futures are long call and short put at the equivalent expiry price. Hence if you are long futures in your trade you can hedge by shorting synthetics, and vice versa.

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