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What is a Contract for Difference?

Article Details
  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 15 October 2018
  • Copyright Protected:
    2003-2018
    Conjecture Corporation
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Contracts for difference are agreements to pay a specific amount that is calculated using a shift or change in some number associated with the option. To a degree, a contract for difference is somewhat like a futures contract, with one very important difference. While futures options usually involved a deliverable underlying asset, contracts for difference do not necessarily have to make use of an underlying asset that is deliverable.

Security trading using the contract for difference may be enacted based on an applicable index future. The contract will specify a specific figure that will apply to each point movement along the index. When a point is gained, the contract demands payment for that upward movement. At the same time, if a point is lost, that also means that the investor loses that same amount of the specified figure.

The structure for a contract for difference can also be compared to the usual pattern that applies to an insurance contract. In both cases, the terms and conditions that apply will include provisions that govern any type of condition that is within the scope of the agreement. Essentially, there are specific conditions that meet any action that is anticipated by the content of the contract.

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One common application of a contract for difference has to do with protecting a company against natural conditions that could take place and cripple the ability of the business to operate. For example, the contract for difference could allow a company to obtain coverage against the chance of natural disasters occurring that would in effect shut down production. Should a covered disaster take place, the company would receive remuneration to rebuild operations. However, if the disaster does not take place, no value is realized.

Many investors choose to work with a contract for difference. Sometimes referring to the strategy as a spread bet, the investor weighs various factors to determine if there is a reasonable chance of making a profit from an upward movement on the index applied. In comparison to other forms of investment, a contract for difference typically does not demonstrate any more or less risk than other types of securities or investing strategies.

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