I'm struggling to understand why the risk on an equity CFD is not the same as for the corresponding equity. The RiskMetrics FAQ mentions two ways to model a CFD, but it does not explain why this is necessary. A good explanation would be appreciated.
1 Answer
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Can you point to a source saying that the risks really are different? See the risk section of the wikipedia page. The market risk of an equity CFD and the corresponding equity should be the same. A CFD trader also faces additional liquidation (leverage) risk and counterparty risk, which an ordinary unlevered equity trader does not. There are also a few other differences in risk due to corporate actions (dividends). Once again, the wikipedia page explains everything here.
My impression is that CFDs are functionally equivalent to futures, except that they are traded OTC and have smaller contract sizes.
answered Jul 26, 2011 at 15:55
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$\begingroup$ I did read the wikipedia article. My confusion comes from the Risk Metrics FAQ I linked to. After reading the Wikipedia article I also did not see why the risk would be modelled differently. $\endgroup$– user1122Jul 27, 2011 at 7:08
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$\begingroup$ @user1122 The RiskMetrics document is just pointing out two equivalent methods of modeling a CFD. The risks are the same. The risk of a futures position is also equivalent to the risk of a stock and a loan. $\endgroup$ Jul 27, 2011 at 12:03
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$\begingroup$ So this brings me back to my original question: why is the risk of a CFD the same as the risk for an equity future (that expires on the current day) and not the same as for the underlying equity? Is this to account for the counterparty risk ? $\endgroup$– user1122Jul 27, 2011 at 22:17
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$\begingroup$ @user1122 which risk are you referring to? I believe the RiskMetrics document is only interested in the market risk. The market risk of CFD = future = stock (except for dividends, which I think RiskMetrics is mistakenly ignoring). They each have their own sets of liquidity and counterparty risks. Since CFD does not expire, they recommend modeling as future with 1 day to expiration to eliminate interest rate risk. $\endgroup$ Jul 27, 2011 at 22:57
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2$\begingroup$ @Jann I believe the answer to your question is to not treat everything written by RiskMetrics like the bible. They included two recommended ways to model the risk mostly because "they felt like it." I do not believe it was meant as a profound statement on the risks of a CFD. $\endgroup$ Aug 25, 2011 at 16:42