Monday, September 26, 2011

Am I Crazy to Short 6-month Italian CDS @ 400bp?

Today was an interesting day.

How so would ask the beautiful female readers (about 5 in the overall 5 females that follow the blog. Yes they're all beautiful)?

During brazilian market hours I was checking some interesting sorta-bull bets that could help decrease overall portfolio volatility, cover some of the downside I am currently exposed to and perhaps even earn some on-the-table risk premium.

I mean... we're here to make good risk-adjusted returns, so we want to make sure that volatility can be high if returns are also high and limiting probable maximum drawdowns.

So why was today an interesting day?

It is simple: I looked at 20-March-2012 Italian CDS spreads. WHAT? Aren't you the guy that believes Europe will blow up? Aren't you long German Dec16 CDS? And all the other bearish trades?

Yes. That's me.
The one who is long JPY March 2014 4% swaption payers because Japan has > 200% gross debt/GDP and > 100% Net Debt/GDP.

Yes, Italy also has > 100% Net-Debt / GDP.

And Italy, contrary to Japan, can't print its own currency.

So why in hell was I thinking about shorting Italian 6m CDS at around 400bps?

Let me be very straight forward here: 400bp for 170somethingdays is around 2% in carry.
That means that the 1.60% I spent for the May14 USDCNY Call would be paid for in case nothing happened to the world and it all looked again as beautiful as the female readers of the blog.

Then we can compare the 2% to the 1.30% or so I paid for the long JPY swaption payers. Also covered.

Then we can compare the 2% to the non-realized profits in the long German CDS bet. Or the long XAUXAG (gold x silver) bet.

I mean... This bet goes against what I have in my portfolio right now. Why would I want to do it? I mean. Italy has to roll some good EUR 200 billion in bonds until March 2012. That is SOME risk if you consider the recent auction results: poor bid-to-cover compared to previous auctions, rising yields overall, rising short-end yields (the curve has flattened remarkably) AND economic activity isn't doing well, Berlusconi is better at hitting on strippers than he is at coordinating a government.

So.... What makes me want to short 6m Italian CDS to collect this hefty risk premium?

Some interesting facts, consider I go short 100% of my NAV in this ugly baby:
(1) At 400bp/yr in carry, I get approx 1.1bp/day in carry. For a ~6m duration CDS.. that means the my break-even rate, at first, goes up by about 1.1/(360/180) = 2.2bps per day. As we get closer to expiration this bp/day increase in break-even rates goes up parabolically (1.1/time left to expiration). With 2 months left, 4 months passed accumulated carry will be 120 days * 1.1 = 132bp. And the break-even from entry would be 400+132/(2/12) = 400+ 132 * 12/2 = 1192 bp. If you look at what happened to Greece once its 6 month CDS hit 400bp.. it took some 8 months to reach 800bp. Well, different case. Italy can't really be bailed-out easily, but...
(2) Italy is the 3rd or 4th largest debt-load on the planet. And in this case this is good. Because if Italy goes belly-up and the recovery rate is, say, 20%.. I lose 80%. Ok. I am long 200% of 5y Germany. That means 200% * 5 = 10x the NAV. So if Germany spreads go up about 300bp, which sounds reasonable if Italy is on the verge of bankruptcy, I get some 30% back from the 80% I lose from Italian CDS. The USDCNY calls should perform nicely too. The EURBRL I do not know. The DI receivers I believe will perform well too. Long Gold / short Silver I think should perform well too.
(3) I believe that European policy makers would quickly find a solution for the Italian sovereign mess in these spreads sky-rocket. Laws and treaties and ECBs bond-purchase programs would be signed rather swiftly in this worst-case scenario. Italians would, by law, be forced into changing buon giorno to guten morgen in a matter of days. (spelling?)
(4) I don't think I can find a 4th reason, but that is why I didn't execute this trade today.


My point here is that: we are starting to see interesting trades pop up.
There are more and more trades that we never thought attractive a few months ago that right now have started to look attractive. And I haven't been drinking, ladies.

I am not going to mention a bunch of "on this hand we have german politicians and on the other hand we have the french who are pro-unity, etc, etc" talk. I openly admit that I am no expert in politics, social contracts or how the italian deficit-reduction plan works. I openly admit that I do not read the fine lines of the EFSF proposal or the on-going SMP program. But I do spend some time trying to understand what goes on in the "only through unanimous decision can European solutions be moved forward". I understand that unanimous, when speaking about many different countries, encompassing different cultures, fiscal backgrounds, weekly-hours-worked, etc, mean "it will take longer than most believe and it will take further deterioration in most countries own situation" for anything to properly be voted, passed and acknowledged.

In the mean time, what am I afraid of? Lots of things.

Perhaps, tomorrow I will add some charts here to explain some of the risk-reward aspects of the trade.
I like these 6m CDSs shorts when they reach these more-than-1bp-per-day carry levels and right now some are laying around. Look at Argentina.

*Disclaimer: charts and data are presented as I receive/see them. Sources are usually not checked for validation and my own calculations are of 'back of the envelope'-type. I am aware that some math that I do myself might be wrong and/or misleading to some extent. In financial markets the rate of change of economic data is often more important than the actual level and the perception of 'what is priced in' is more important than 'what is actually going to happen'. This is actually the way people pick entry and exit points. So... yes, sometimes you might say 'This guy is an idiot, this is way wrong!' with a high conviction, being right. Not to worry. Markets are made of expectations and the clash of conviction between its participants. Portfolio managers know that being an idiot is sometimes profitable and being smart is often a bad choice. It is all reality, sometimes good, sometimes bad. By the way: corrections to my analysis and intelligent debate is welcome. theintriguedtrader AT gmail do com


  1. I'm not a cds trader so you may laugh at this....

    It sounds like you are trying to play the relative value of the various cds markets in Italy/ Germany and squeeze value out of an arbitrage situation.

    IIRC T2 partners did something similar with the BP situation. They sold CDS and bought stock puts. In almost any situation they would have made money, and they did. You are just doing it with different countries instead of a capital structure arbitrage.

    Why don't you look at the some of the Asian countries which probably won't go boom when Greece defaults? I've heard the CDS rates have gone up a bit recently (yeah its not 400...)
    Yeah the premium received won't be as much but the chance of default is much lower. You seem drawn to the premium like a moth to a flame. You know you'll get burnt but still......

  2. Actually, I am not trying to play the relative value.

    I am simply trying to earn risk-premiums that are laid out on the market-table.

    Do I believe Italian debt fundamentals are horrible? Yes.
    But I also believe that until March 2012 Italy won't default.

    So earning 400bp (annualized) for such a bet sounds interesting.

    If this bet is solid, profitable there are 2 possible outcomes: (a) the european debt burden will have fallen on Germany's shoulder and the German CDS trade will likely play out or (b) things might have deteriorated further until March 2012, but without an Italian default and German CDS will look worse too, but this Italian short-term play will have expired.

    In terms of Asia: most of Asian CDSs that you mentioned are probably the 5-year tenors. That is a lot more duration risk and at a lower much lower carry. I don't want duration risk, just the carry-to-maturity.

    And I do not follow asian nations much so confidence in what their political systems and policy making tools are, in default-like scenarios, are not for me yet.

    I need to spend more time studying them.

  3. In comparison: 6m Italian CDS has a duration of 0.5, while those Asian ones are 5y, so 5/0.5 = 10x more duration risk.

    In context:
    5y Chinese CDS @ around 150-165
    5y Indonesia @ 270
    5y Philippines @ 230

    So... 10x more duration risk for 50-60% of the carry.

  4. Heh, yeah I can see the attraction of the Italian CDS 400 for 6 months as compared to the Asian pricing.

    Hey, you are the hedge fund master of the universe, I'm just a money manager.

  5. Let's just say that the 6m CDS was bid @ 410bp.
    Now offered at 330bp.

    Talk about shooting after asking questions.
    And there aren't any masters here. Just a lot of hard work in order to increase the 'luck' factor! ;)

  6. May I ask you when did you enter the JPY payer trade? I think I have read you have entered it at ard 130bps and I don't think it has ever traded higher than 100bps back in March. I suggest to check prices with more dealers next time.
    Re the 6M Italy CDS, it does definitely look good, gap risk is high but the carry is very good for 6M, Italy not going to default in a second anyway, Greece should have defaulted ages ago and they are still arguing...

  7. JPY Payer: vols spiked up around quake-time. I checked with 6 dealers.
    Now worth about 50-60bp.

  8. ok then you must have really bought them soon after the quake. No offense, I was a bit surprised about the market reaction to the quake as well, but those payers were a "screaming sell" at the time and they still are after vols have dropped considerably!

  9. I think this is a very good trade to put on. As being one of the most bearish on Europe, I'm pretty convinced Italy's is the only PIIGS that won't go down. Also crises tend to always take more time to unravel than we think. My feeling is that we are still way more than 6 months away from the explosion of the Euro.

  10. @Ion.Italy: 'Screaming sell' because you likely believe all is fine with Japan , that japanese population will be able to afford purchasing JGBs forever and that mkt players will go on selling OTM vol forever, receiving rates. That has been the example in the past years, no questions asked. But one day they Japan will be proven insolvent. Somethings just can't go on forever. Just like selling 5y Sov CDS on Germany, Greece, US, Italy went on for years below 10bps...

    If you study fundamentals and the possible risk-reward you will understand it sounds like a very interesting bet that could even benefit from a growth outburst (which I don't believe will happen in the next 5 years).

    The idea is to build an interesting portfolio, based on fundamentals. Getting the timing right on such trades is tough, so a longer-term bet, that is more expensive, suits my trading profile.

    If I get this trade wrong, but the overall portfolio's returns are high (risk-adjusted) it is fine with me.

    @Greg PBA: Indeed, but now bids are lower, got to think. Argentina CDS at around 800bp also sounds very interesting in my humble opiniong. Debt levels are much better than Italy, but it has no German on its side to save it.. But again, same maturity, Mar12.

  11. @Ion.Italy: btw, around 2-3 days before I actually executed the 3y10y 4.0% payer was around 100-105bp. So, yes: execution was bad enough. But I got till early 2014 to be right.

  12. I have exactly your same view re Japan and been struggling to understand how Japan manages not to explode/implode (depending on the viewpoint). I had bought the same 3y10y 4p in oct10 at 46bps when I thought skew was still relatively cheap and loaded on cms caps at very cheap levels. What I meant it's not that the view in absolute is wrong, but there is a value for everything and skew back in march was terribly overpriced and it's still terribly overpriced. Carry is horrible and mine was just a purely RV consideration