Pricing political risk in a crisis is hard. Exhibit E: the “orderly transition”.
1. Hosni Mubarak says he will not run for re-election. Reuters flash at 9am GMT (H/T FT Tilt):
Egypt debt insurance costs fall sharply-Markit
2. Some Egyptians are — unsurprisingly and understandably — less impressed with Mubarak’s speech. Cue violent clashes in Cairo.
3. And cue a rethink about that CDS pricing. Reuters flash at at 3:41pm GMT:
Egyptian debt insurance costs rise after clashes-Markit
So what to do about all this volatility?
Citi has an innovative answer: the Middle East Convergence Trade.
This means selling Egypt CDS and buying first-to-default protection on a basket of MENA countries, including Egypt. If the non-Egypt countries’ spreads widen relative to Egypt — hey presto! And if Egypt defaults or if Egypt 5-year spreads tighten then losses will be less than with the previous product.
In other words:
The ‘convergence’ structure involves simultaneously buying FTD protection on Egypt and a basket of regional names and selling the same notional amount of single name CDS protection on Egypt. At the cost of some carry, investors get the benefit of the FTD’s gamma and significant upside if one of the other names in the basket widens. This gamma means that if Egypt spreads widen towards near-default levels, then the change in the MTM on the FTD will match the change in MTM on the single name CDS position. If, on the other hand, spreads tighten, then the single name CDS will outperform the FTD, resulting in profit. This relationship works best if the trade is entered into when Egypt is very wide and the rest of the basket is considerably tighter.
Simple.
Citi recommends a hedge involving Egypt, Israel, Abu Dhabi, Bahrain, and Morocco (click to expand).
There are sensible reasons for this selection — for example the lack of liquidity in alternatives such as Syria and Jordan — but on first glance it seems less likely to offer the credit widening the hedge requires.
But given recent, less than prophetic predictions of political risk, any ideas for hedging will likely be welcomed.
Related links:
In Pharaoh’s markets – FT Alphaville
In Pharaoh’s markets, part two – FT Alphaville
Egypt coverage – FT Tilt (subscription)