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Is The Quanto CDS Trade The Most Profitable Way To Bet On The Eurozone's Collapse?
A massive arbitrage has developed in European sovereign CDS, where the differential between local and foreign-denominated (euro and dollar most typically) CDS has jumped to record spreads. Case in point Germany, where €-denom CDS trade at 30 bps, while the $ equivalent is 43 bps, a 30% spread differential. The reason for this is obvious: as concerns of pan-european defaults have hit the euro, getting paid off on euro-denominated default protection seems increasingly less attractive. Should, say, Germany default, €10MM worth of protection on a German credit event would be worth much less at default which would certainly be accompanied by an almost full devaluation of the euro, resulting in a huge hit to the "at converted" currency, presumably dollars (as the euro would no longer exist). This has led to a major drop in demand for EUR-denom German (and other European) protection, with the differential hitting the abovementioned 30% margin. As Fitch discloses, this spread was just 7% in January. As this is a second derivative play on both currency devaluation/vol and increasing default risk, arguably the most profitable way to bet on a the confluence of factors that impact the eurozone could be a simple quanto swap trade, which could reap massive rewards should peripheral or core European weakness persist.
As Nicoletta Kotsianas from Debt Wire reports, "The higher the differential between sovereign credit swaps in different currencies, the higher the correlation between default risk and volatility in the relevant exchange rate. Aside from expressing that somewhat obvious trend, the dual-currency CDS dynamic creates a trading opportunity using quanto swaps... Demand for quanto swap prices - FX swaps embedded in CDS contracts - has picked up over the past month as investors look to track the differential... Actual trading in the swaps is limited but could pick up as macro investors seek out new ways to short European credit and currency risk."
She goes on to point out that the ever imaginative Wall Street analysts have bypassed quanto FX swaps and created quanto CDS directly: a quanto contract: "is quoted on all the major sovereigns in addition to single name corporate swaps and CDS indices. It is quoted as the spread difference between the standard currency CDS and a second currency. For example, five-year sovereign CDS on Spain trades at 200 bps, while quanto CDS on the country is quoted at -32 bps, according to the second analyst. This means the seller of quanto Spanish protection will get 168 bps running while paying 232bps in the event of default." Not a shabby arbitrage for the counterparty should Spain blow up. The most profitable outcome occurs when "the fx spot rate has to move and a credit event needs to occurs."
Bottom line here is that even as every Tom, Dick and Harry now quotes sovereign CDS spreads like they are the cup measurements of Lindsay Lohan, there is a fluid world beneath, which courtesy of Wall Street's ingenuity has found a brand new, and much more leveraged way to take advantage of the Eurozone's "common currency" fatal flaw. We are convinced that once the EMU is a long-forgotten memory, quanto speculators will first be reviled, then seen as geniuses, and lastly go broke, once the dollar printing mania takes over the world, as the quanto trade moves to the US and all CDS traders self-cannibalize, by profiting on the quanto moves as the US itself goes bankrupt. The only question is what other currency will be arbed against the then-hyperinflating dollar.
For those who wish to read up more on the quanto swap phenomenon, please see the following presentation from Barclays.
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Another question.
Why not take a view on debt that you think will come under pressure, say Belgium. Buy protection with a 2Y tenor and sell 5Y protection? If no default, then cash in. If there is a default, then you break even.
Is the bid-ask so wide that the trade wouldn't work?
Belgium CDS? Now THAT is what I am talking about.
Wait a minute....do I have to denominate in Euro-trash-girls, only, versus Bernanke Bucks? FUCK!!!!!!!!!!!!! I hate trading w/ currency beta. It's like dating more than one girl. Too many variables.
ROFL
Where's Armando to take the contraian side of the trade?
Bet, he could make millions and live a life of almost drug cartel dimensions in his South American paradise.
Is it possible get an SDR denominated sovereign CDS?
Give it a little time and they all may be, although this trade's a little irrelevant at that point.
Someone is going set off one of these WMD's and get themselves invaded... watch the French...
Do you mean the French at Goldman Sachs?
OK, so I thought exotic derivative financial engineering was at the root of our malaise and now you advocate more exotic betting.
There is no free lunch in slicing and dicing risk.
STOP THE MADNESS!
Watch what happens my friend. Let them dance.
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Very cool. Can I get one with the word 'Fiatsco" like that with a picture of Bernanke's face in the circle for the back of the shirt?
EURO-PEAN DEVALUATION:
http://williambanzai7.blogspot.com/2010/04/euro-pean-devaluation.html
Okay, here's what the Germans do...
Keep sweet talking how they'll back the bailout up until the last moment while liquidating their remaining PIIGS bonds at whatever they can get for them. Then announce they will pull out of the eurozone and return to the Deutsche Mark. Reassure German citizens and businesses they will honor euros at a 1:2 exchange rate and kiss goodbye to europe and the euro.
It would be cheaper than subsidizing Club Med retirees for the next few decades, if you ask moi.
Only problem with that is no more vacations south of the Tirols. :-(
At least not until the Bundestag closes on the Cyclades. ;-)
Como sedice "quanto swap trade" en ingles? Also "simple quanto swap trade" is an oxymoron. By the time I figure all this $hit out the knowledge may be useless. Onward through the fog...
Did anyone actually understand that on the first read through? A little bit of my brain just leacked out my nose onto the keyboard.
The victim on the carpet is dying.
Lets help him. No lets not , we should let him die.
hey, lets bet on how long he lives.
To me the entire wallstreet scene stinks of immorality of the highest order.
Actual people suffer and die because of these wonderful deals.
protecting onesself financially is one thing, but to attempt to reap reward from others misery is as bad as childmolesting.
call it like i see it.
I can see the single job ad in the paper tomorrow.
Wanted:
Computer programmer with knowledge of c, c++, cobol, fortran, etc
Job Description: Create algos for HFT cross-currency swaps
No eVerify required!
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Now convert into any non-extradition country's currency on the go. Less fuss. Less scrambling to convert as the currency drops.
Sounds like TD just spotted the next place the use of derivatives is about to explode.
Of course the exit stalls on this one is more like an escape pod. It can only hold a few, and once its gone, good luck.
This isn't an arb; it's a way of holding a particular kind of risk. Sovereign CDS is by nature done as a "quanto"--i.e., the deal is done in some currency other than the name's native currency for the obvious reasons stated above.
If you're a EUR investor who wants to sell protection in USD on say Germany, you can create positive carry by buying protection back in EUR, but that carry is compensation for FX risk. If Germany does default, your protection pays in EUR, but you owe a protection payment in USD. One huge risk of the trade is the FX rate given default.
There is also, as always, the inherent structural risk of CDS: If the default risk of the party you're buying protection from is highly correlated with the default risk of the reference name, then the protection you're buying isn't worth much, since it's apt to evaporate at precisely the moment it's needed. Or, to use Taleb's gloss, it is like buying insurance on the Titanic from other passengers on the Titanic.
So...the fact that anyone touts this trade is exhibit A in the perversity of the credit derivatives market, which really trades spreads, not default. The risk of spread movements and the risk of an actual default ("jump risk") are in essence treated as separate things, and many credit strategies are robust against the former but not the latter.
+100
It's the same as buying stocks in other markets and hedging currency exposure...nothing fancy about it
I'm all for the KISS investment strategy, just buy Gold and short Euro Stoxx Banks futures contract
All this CDS lingo makes my head hurts and it's way too complicated to know who is the counterparty and the conditions to reap the reward.
Look at who bought the CDS greek bonds, they're not getting a payout unless the ratings agencies admit defaults....
gamechanging/enlightening post of the year imo. there's no precedent for interconnectedness & contagion risk this large in a monetary union clusterfuck with different fiscal systems. if quanto arbing is becoming status quo for sov bond hedging, the perception of stability is absolutely gone and the worse things get, the even worse they get.
this really does solidify a collapse in the EMU/euro in my opinion. there are no delusions about the euro's soundness/future, at least as far as capital markets funding the entire content are concerned, and to paraphrase the Joker, the euro will come face-to-face with gravity soon, as truly "all it takes is a little push" from here.
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