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The true cost of borrowing

Created:
25 November 2005

"Stake a penny, win a pound," could be the slogan of spread betting. The chance to make big profits from small initial deposits is one of its biggest attractions.

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And what spread-betting companies did in the late 1990s was to extend this sort of financial leverage from City dealing floors to the general public.

But if it sounds too good to be true, it is. All financial leverage involves borrowing. Finance charges are the cost of that borrowing.

To see why, consider two alternative ways to make £10,000. You could go to a bank, remortgage your house for £100,000 and invest that money in a FTSE 100 tracker. If the index rises 17 per cent in a year, you will have made a £17,000 profit. But your bank will have charged you interest on the £100,000 loan. At 7 per cent, you will pay £7,000, taking your profit down to £10,000.

Or you could spread-bet on the index with a 5 per cent margin and an initial stake of £10,000. That gives you exposure to £200,000-worth of the FTSE. Suppose you dip in and out of the market several times. Netting off your winning and losing trades, you make £13,500 profit.

Adding up all the days and weeks your capital was committed, it turns out that you were actively invested for just three months. You would pay roughly £3,500 in finance fees (or £200,000 at 7 per cent charged for a quarter of the year). Your net profit is £10,000.

When you trade on a 5 per cent margin, you expect a gain that is 20 times the gain on your deposit. Somebody is contractually obliged to hand it over. That somebody needs to find the money from somewhere.

In theory, they do it by borrowing money on your behalf and investing the full amount in the position you have selected - long of Vodafone or short of the Dow. When you close the trade, they close their big position and hand you the profits (if you have won) or the bill (if you have lost).

When someone borrows money on your behalf, he ties up capital that could be used to earn money elsewhere. To compensate, you will be charged financing fees.

How financing fees are worked out Most spread betters calculate their fees based on Libor (the London inter-bank offered rate) plus or minus a set amount. Libor is a short-term interest rate set by the Bank of England that fluctuates each day but is rarely very far from the Bank's headline base rates.

For daily rolling bets, most spread betters charge Libor plus 2-3 per cent when you take out a long position. Occasionally, though, you will see a rate of Libor plus 0.5 per cent or even 0.25 per cent. This is not a bargain. It almost certainly refers to a futures contract, which will already have a finance charge built in to the price.

For example, Cantor offers a financing rate of Libor plus 0.5 per cent for its quarterly shares contracts. It does not yet offer daily bets but, when it does, the daily funding rate will be 2 per cent above Libor.

If you short a stock, index or commodity, you receive interest. This strikes many novice traders as odd. The best way to think of it is to imagine how shorting is possible in the first place.

In simple terms, your spread better will approach a long-term holder of a stock - say a pension fund or unit trust. It will borrow the shares and promptly sell them in the market, ready to buy them back when you close your position.

In the meantime, there is money left over from selling the shares, which goes into an interest-bearing account. The spread better will earn the full interest, and pay you a rate of Libor minus 2-3 per cent.

In this way, you are paid to short shares. See the table below for a list of spread betters' interest rates for long and short positions. Be aware, though, that some spread betters charge a daily roll-over fee, which would add to the effective interest rate you pay.

Remember also that the long-term owner of the shares will charge a fee for lending them out and can call them in at any moment. And in a plunging market, it can be hard to find anyone fitting the bill of a 'long-term owner'.

So when a stock becomes hard to borrow, it will become more expensive to short. The spread better may cancel interest payments or even charge you to cover his costs in shorting the stock.

In addition, remember that the interest you pay is on the value of the total position - including your initial margin or deposit. That total is bound to fluctuate over the course of the bet. So if you are long of the FTSE 100 and it surges, your interest bill will jump, too.

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