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Is The Quanto CDS Trade The Most Profitable Way To Bet On The Eurozone’s Collapse?

Courtesy of Tyler Durden

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.”

A not quite apples-to-apples visualization of this phenomenon can be seen by the following chart from Barclays, indicating the cash curve of France Telecom:

A simple arbitrage play can be derived from the preceding. As BC explains:

This creates a pricing differential that can be taken advantage of using cross-currency basis swaps. Figure 6 highlights the economics of investing in the two sets of bonds marked out in Figure 5. The spreads indicated are over 3m Libor, for a par-par swap in each case. As indicated, an investor buying a sterling bond with a cross-currency swap actually picks up 40-60bp more (above swaps) than a euro bond of slightly longer maturity.

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.

 

Attachment Size
BC Quanto.pdf 405.54 KB

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