Wednesday, November 24, 2010

The Beginning of the END

The situation in Europe has hardly improved over the past 24 hours. A raft of stronger European PMIs and German IFO figures that all outperformed expectations did little to lift mood and go to emphasise that the problems are sovereign-based rather than in the private sector. This morning has seen further blow outs in Eurozone peripherals and associated liquidity trades used by the market to hedge the periphery meltdown tail risk. Specifically, things like EURIBOR/EONIA basis and EUR/USD Cross-Currency basis have been moving sharply, bring back bad memories of May (not 2008, as some are trying to suggest).

Of course this has all added fuel to the "End of the Euro" Army who are being wheeled back out into Media space. More elderly occupants of FX dealing rooms are reminiscing over the old cries such as "Get me Mark/Spain calls", pondering if they might just return one day, raising a glimmer of hope for the drivers of "FX Taxis" where many old EMS FX-Cross traders ended up in the late 1990s. Of course, the 12yr old French quants in the room haven't a clue what they are talking about but smile politely.

TMM have had a think about this and the processes involved in moving from a single Euro to separately tradable sovereign currencies, should it happen. Whilst Euro-Apocalypstas seem to suggest that the move would be a step change, we would like to suggest that the process will mirror the evolution of other emerging markets. In these cases, the markets develop their own products to facilitate speculation hedging before they become officially freely tradable. Namely, the Non-Deliverable Forward (NDF) market. And so it should be with Europe.

So TMM would like to present the launch of a new product to facilitate such "hedging" called The END (European Non-Deliverable) market.

So how would they work and what would be the underlying hedge?

It turns out that the re-denomination clause in Sovereign CDS for G7 countries allows these guys to re-denominate their debt without triggering the CDS. This is particularly interesting in the case of Italy (coincidentally, a G7 member) and provides us with a way to get long Mark/Lira without paying away copious amounts of carry. So, think about doing the following set of trades:

  1. Short 5yr Italian Bond funded on reverse repo (currently, 5yr yield is 3.488%).
  2. Sell protection on 5yr Italy CDS (currently 206bps).
  3. Buy 5yr German Bond funded on repo (currently, 5yr yield is 1.626%).
  4. Buy protection on 5y Germany CDS (currently, 43bps).

If you add (1) and (2) together, you effectively have a short position in a risk-free Italian bond (usual CDS/basis caveats apply) that has the interesting characteristic that if everyone's favourite Italian, Uncle Ber-lech-sconi, decides to readopt the Lira, you are short an ITL-denominated bond and the CDS doesn't trigger. On the other hand, if they keep the Euro and restructure then you are hedged (again, usual CDS/basis caveats apply). The opposite is true of (3) and (4) - if Germany readopted the Deutschmark then you are left holding a DEM-denominated bond with credit risk hedged (although I'm sure no-one would bother buying protection on Germany). [As an aside, although most iPIGS CDS trade with the re-denomination clause, TMM is sure that variant contracts will eventually appear].

OK, so how do we price a DEM/ITL END ? Back in Finance 101 TMM remember learning how to price FX Forwards (Covered Interest Rate Parity and all that bollox). Without going into too much detail, and again with all the usual caveats, the 5yr Italy risk free rate is going to be something like 1.43% (=3.488%-206bps) and that of Germany is going to be about 1.2% (1.626%-43bps). Now DEM/ITL was pegged at 989.99, so plugging all the numbers into the FX Forward formula chucks out an outright 5yr forward rate for DEM/ITL of about 992.46. And that seems ridiculously low to TMM.

The first chart below shows the history of the 5yr END and the second shows the FX Forward Points.

Of course there is no guarantee that, upon leaving, either country would readopt their old currency at the levels they entered the Euro (they could have the NuovoLira, or NeuMark or whatever). But the above is illustrative that the market could very easily start trading contracts based upon Euro-exit as the hedge does not depend at all upon the new currencies or rates that they re-denominate at (these are, after all, purely arbitrary). TMM reckon that it would be pretty easy to trade their ENDs purely as the implied interest rate spread with a contract clause to add in the appropriate new Mark/Lira exchange rate upon exit, given its arbitrary nature.

So, who's going to be first to trade their ENDs in Euro ?


Anonymous said...

20 euros yours

Anonymous said...

fucking ©-free?

FX said...

There is a missing oldie but a goodie from TMMisms.

Turds: those mortgage related thingme bobs on banks balance sheets, most notably mention here in reference to the Euro Zone.

"Turds' yeah I know I can hear you all laughing from here,but f%^&it, I bet 50 cents can't trade the cable like I can, is'nt that right old timer.

Anonymous said...

something wrong with calculation...

989.99 x (1+1.43%)/(1+1.2%) = 1001.87 not 992.46

Am I missing something??

Anonymous said... mistake...forgot about the's approx 992

Belektron said...

I think USD is fundamentaly not in much better position than EUR. It is just about market press headlines in a certain point in time.
So what should we save in? I was never a fan of PM but have put 20% of our portfolio in gold recently. Could be described as an act of desperation :)

FX said...

The Dow going to be twice shy when Oil breaks previous high coming out of a downturn.

leftback said...

Leftback can confirm from his temporary perch in the UK that things are going pear-shaped in a hurry in Europe. It was certainly interesting to read yesterday's missive from TMM confirming that traders are making concrete plans for the withdrawal of weaker and/or stronger economies from the €.

For as we all know, market participants are painfully aware that An Official Denial actually means Yes, We Are Bankrupt and Yes, We Will Be Doing That Haircut Thing but we don't want the General Population to know just yet.

leftback said...

Sorry to perseverate on this issue, but it occurred to me that this is all completely predictable. If you are a banker named José, and your bank is insolvent but you have a large trading operation, you can simply have your amigos on the fixed income desk short the govies of your own country, say, España, against the govies of another solvent country, e.g. Deutschland. Then when the rates are high enough, your government demands a bailout of its banking system, and you then use the resulting monies to buy the govies that you had been shorting, while advising El Jefe to begin an austerity program that results in lower rates via deflation. A year later you pocket the profits and announce that you have successfully replenished your Tier 1 assets and recapitalized. Your fixed income boys get a big bonus. Meanwhile, in another country, a banker named Giorgio is shorting the govies of.....

Repeat, serially, around the world.

Anonymous said...

"The opposite is true of (3) and (4) - if Germany readopted the Deutschmark then you are left holding a DEM-denominated bond with credit risk hedged (although I'm sure no-one would bother buying protection on Germany)."

If Germany left the Euro (the most likely scenario in my opinion - the Euro would depreciate without causing all of the chaos of weaker members exiting), is it automatic that they would re-denominate their debt? Seems to me (if they could get away with ti) that they would prefer to maintain their liabilities in a currency destined to continually become weaker.

Nemo Incognito said...

LB, sitting at a large former investment bank I can tell you that your recent comment does sometimes look like a pretty accurate summary of how the world works.

theta said...

Wait, isn't it 989.99 x (1+1.43%)^5/(1+1.2%)^5 instead? which gives 1001.291139 as an implied fwd.

IF there's a breakup of the Euro, even 1001.29 is ridiculously low for the DEM/ITL rate. It would probably be around 30% higher. However, that's a big IF and there's your answer to why that's the current implied fwd END rate. If you assign a probability of 10% to EUR breakup, then the probability weighted fwd (which is what you actually get and pay for) seems fair, no?

Nemo Incognito said...

I think the appeal here is that unlike the short sovereign cds game this is a bit more clever as you're betting upon where it will be post breakup. To that end its a bit like a recovery swap though there is some carry cost involved.

leftback said...

Irish bailout ready to hit the markets. Some participation by the Irish pension funds in the bailout, maybe 20% of the cash (!) and the rest is from a variety of countries, it all adds up to €85B, at an average interest rate of 5.8%. This is an appalling political development for the Irish people, but politics isn't my patch.

Bondholder haircuts are off the table so that means that the European bank stocks will bounce and US banks will probably follow. Treasuries will probably be sold as investors exit safety trades.

You would think that this might stabilize EURUSD for a while. But with US employment reports lurking to provide additional USD support, and Portugal and Spain next in line for the bond vigilantes, it seems unlikely that we will see more than a very brief resurgence of DGDF and the commodity trade.

Sell the rips in EURUSD and in the emerging markets is how LB sees it. There may be downside for the USD in the immediate future but it isn't going to last long. LB is watching AUDJPY as risk proxy. Both currencies have been weak lately, so to me there is no clear risk-on or risk-off signal for US equities and high yield credit for the time being. Sideways trade in the US and some frantic exit rallies in EMs?

FX said...

Risk on - risk off signal? don't forget our risk barometer, it just about to break.

FX said...

I don't have a clue who pushing that thingme bob around but those guys are spot on.