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The price of EUR-denominated credit default swaps referencing German sovereign bonds is now nearly 30% cheaper than the same contract denominated in USD, according to data from Fitch Solutions and three CDS traders. Far from reflecting a view on German default, the massive differential – up from only 7% in January – provides a proxy for market sentiment on the EUR as fear of contagion spreads, two analysts told Debtwire.

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, according the first analyst and a CDS trader.

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, noted the second analyst. 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, said the second analyst.

The risk of a domino effect in Europe provides more reason to position for a further drop against the dollar, said the analyst. “[The ECB and IMF] were slow moving with Greece, there is nothing in place for Portugal and Spain,” noted a third trader.

In the case of a EUR-denominated German CDS, if the EUR/USD exchange rate continues to weaken, it will cost the seller of the contract more to pay off the buyer in an event of default because the swap settles in USD, said two of the traders. Sovereign CDS typically settles in an opposite currency so that the inevitable devaluation following default does not erode the value of the contract, explained the second analyst.

As a result of the situation in Greece, demand for EUR-denominated Germany CDS has disappeared, noted an analyst and two traders. USD-denominated protection on the sovereign is quoted at 43bps while the EUR-denominated contract is marked at 30bps, according to the analyst.

The differential first jumped sharply in early March but given extreme foreign exchange volatility, the upward sloping trend based on a moving average was firmly established in mid April, according to the Fitch analysis. The fact the differential has widened out for Germany – a sovereign with very little default risk – illustrates that the market is pricing in increased contagion issues for the currency and the fears are seeping into all credit related products that settle in euros, noted the CDS traders.

The same dynamic developed in reverse from early 2008 to early 2009 in Greek sovereign CDS trading when the credit crunch hammered the USD. The USD-denominated contract on Greece was more liquid than the EUR-denominated swaps until May 2008, according to Thomas Aubrey, managing director at Fitch Solutions. CDS written in EUR took primacy for the following years before USD-denominated contracts once again became more popular, he said.

Investors can arbitrage these swings through quanto CDS, which is quoted on all the major sovereigns in addition to single name corporate swaps and CDS indices, noted a second analyst and the traders. 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 200bps, while quanto CDS on the country is quoted at -32bps, according to the second analyst. This means the seller of quanto Spanish protection will get 168bps running while paying 232bps in USD in the event of default.

For investors to monetize a quanto CDS position, the fx spot rate has to move and a credit event needs to occur. The buyers and sellers of the quanto swap take opposite views on the correlation between currency and credit risk, explained the first analyst. For example, euros will depreciate as underlying spreads widen. Investors can also profit on a mark-to-market basis as the two legs move.


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