Back in June, Barclays Capital recommended buying quanto CDS on Greece as a way to profit from, or hedge against, a depreciation of the euro against the US dollar upon an eventual default of the sovereign. Given how close we may be to that outcome, what can this particular financial product tell us about the potential impact of a Greek default on the value of the euro?
First, let’s take a look at the bizarre world in which quanto CDS are actually able to exist.
The currency of sovereign CDS
Within the universe of credit derivatives that reference just one single entity, CDS referencing sovereigns comprise nine of the 10 most popular credits and the net notional referencing all sovereigns is 21 per cent of the overall single-name total.
The majority of sovereign CDS are written in a foreign currency. For example, it’s more common to have a contract referencing $10m of notional exposure to Italy than it is to have €10m.
Concerning why that is – if a sovereign did default, you’d probably be a little disappointed in the payout you get if it were denominated in the domestic currency. By way of example, would you want a payout in euros or dollars if Italy actually managed to default?
Most investors would want a payout in dollars, given the amount of euro depreciation that would likely accompany a default by such a large eurozone country.
However, financial contracts like CDS aren’t always about hedging tail risk. Sometimes they are used for asset-liability management and for smoothing what would otherwise be stomach-churning mark-to-market swings. Coming from this perspective, having the hedging tool (CDS) and the thing being hedged in the same currency may be attractive.
While it may instinctively feel like a step towards the cliff of insanity to buy Italy CDS in euros, it’s not quite jumping over the edge given the nature of monetary union.
Long story short: sovereign CDS are mostly denominated in dollars, but for eurozone countries, it’s also possible to see euro contracts floating around.
Enter, the quanto!
Given that CDS on Italy can be traded in both euro and dollars, it was only a matter of time before a trader bashed them together and came up with a cool sounding name for the “new” product.
“New” because there are quantos on plenty of other financial products, it was just new to apply it to CDS. And at least what they didn’t come up with another acronym for it. (Note 1)
On the occurrence of a default, provided it constitutes a credit event in the CDS world, the buyer of a quanto gets:
[100 - Recovery Rate]* [%USD:EUR change]
That means the buyer gets compensated for any depreciation of the euro against the dollar, and quantity that is covered is the amount that is paid out from the seller to the buyer as determined by a credit event auction.
The seller, meanwhile, is motivated by the carry, i.e. the regular payments that they receive. Quantos on European sovereigns have historically traded in the range of 5-120 bps.
What price, the quanto
The quanto spread is primarily driven by three factors. Here they are, courtesy of a brilliantly titled note by Barclays Capital, “Quanto of Solace”:
1. Expected change in FX rate following a sovereign default
2. Correlation of the FX rate to the CDS spread (with or without default)
3. Illiquidity premia for the less common EUR contract
It’s the first point that allows one to get the quanto-implied expected depreciation in the euro upon default. Or put more precisely, and with a non-trivial disclaimer around assuming away hedging and frictional costs:
Expected[EURUSD on default] = €CDS/$CDS * Spot EURUSD
Quanto, says
Bank in June, the situation looked like this:
Barclays Capital adds this on the “weakest sovereigns” and “systemically important peripheral sovereigns” bars (emphasis ours):
Weak sovereign credits (Greece, Ireland, and Portugal): For these countries, default is a realistic scenario and there are two main technicals at work. Firstly the market has had enough time to digest the implications of a default and considers it to be an event which will likely have a contained impact on the eurozone. Secondly, most of the potential impact of a default on the FX rate has already been priced in over the course of the past year. There is little element of surprise left in case of a default by these sovereigns.
Systemically important sovereign credits (Spain, Italy, and Belgium): For these countries default is unlikely, but in case it does happen, macroeconomic conditions can be expected to have deteriorated sharply. Thus defaults of these sovereigns are likely to have a very broad impact on the whole eurozone, and the quanto market prices in EUR close to parity with the USD in these scenarios; a depreciation of ~30% from current levels.
Barclays has another interesting chart about “pricing in”, which looks at how the quanto-to-spread relationship changes as the credit deteriorates:
This chart, which has data from November 2009 to June 2011, is meant to demonstrate how the quanto spread decreases as the spread widens beyond a certain threshold.
The story goes that as CDS on Greece deteriorated, the expected depreciation of the euro from spot upon default increased. However, as the credit deteriorated even further, the depreciation became baked in already so that the price of the quanto started to fall.
However, FT Alphaville hears that the trend reversed for awhile over the last couple of months, with the quanto increasing in price again as market participants began to look at Greece’s default as being more akin to the straw that broke the camel’s back.
Here’s an updated chart that uses Markit data.
The use of Markit data for the updated version of the chart means that these are in fact implied quantos. That makes the implied depreciation of the euro an implication of an implication, or an implication-squared.
Or in short, take the above implication-squared of the depreciation of the euro already being baked in with a grain of salt. Perhaps even with a cube of salt.
The whole reason, however, that implied quantos have to be used is that it seems that the spring’s surge of interest in this product has since dried up. We’ll be keeping an eye out to see what happens next.
(H/T Theo Casey)
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Note 1 – Notwithstanding the above, FT Alphaville positively encourages Star Wars-themed names for new products and trades. This makes our job much, much easier. Thank you.
Related Links:
Quanto CDS flows return – IFR
Quanto CDS gaining significance in the Greek trade - CreditLime
The market for sovereign default recoveries – FT Alphaville