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 ?