A CDS, just spelled differently

Still dogging the euro, I have to admit that I have always been a euro sceptic, despite the effective basket currency approach.
 
Options traders will know that if you spread risk (through the inclusion of differing risks) then the overall risk decreases and so does the price of an option. Follow me back 20 years if
you will.
 
Let’s say you thought Greece was over extended and you wanted a put option (an ability to sell at a given price). Given today’s data, you would pay a very hefty sum to do just that.  If you included a basket of currencies into your ‘Greek sell’, hmm, let’s say, French Franc and German Deutschemark (I actually had to think about those!), the risk, or cost would fall significantly.

 
So what’s changed with the advent of the euro? Well, in short, not much. The cost of a put is still reduced by the inclusion of several countries; it’s relatively cheap to sell Euro. The difference is in the debt markets. Seemingly the price of the euro is dependent on the whole euro group; however your loans are just that, your own lookout.  This explains the difference in pricing of debt, Germany being the benchmark of economic stability, Greece, Ireland, Italy and Portugal being on the other end of the scale. 
 
Factor this into the FX forward market which adjusts a spot FX price by the difference in interest rates between the two traded currencies and you have an anomaly: should you buy a ‘German’ euro you would expect much less of a discount than buying a ‘Greek euro forward – being that Greek ‘euro’ interest rates are much, much higher than German interest rates.  So how does it actually work? Well you have the ECB ‘official’ interest rates. You could easily buy a ‘German’ euro and lend it to a Grecian with a significant pick-up and zero FX risk. Whether you would get your money back on the lend is debatable, but probably, yes, the pickup is around 300 basis points, pretty good for no FX risk, oh yeah I forgot that’s a credit default swap.

Over to the rest of the world and long term bets (aka dead certs), dollaryen is around 93.00 to the dollar. Logic and the Bank of Japan reckon the real price is 120.00, so buy dollaryen, at the moment zero carry cost (you get nothing on your USD or JPY).  It maybe a couple of years for a 30 per cent return…hmm, maybe not so bad.  Also think about shorting NZD and AUD (if you have deep pockets), both are outside their comfort zones and “should” return to the median at some point. As with everything, timing is crucial: go too early and be destroyed every day with yield, too late…and we’ve all been there.
 
Too much opinion in this article, I will revert to my usual fence-like approach next month.

Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Cayman) Limited.  The Bank accepts no liability for errors or actions taken on the basis of this information.

 

 

 

 

Phil-Turnbull-SM

Money Markets By Butterfield’s Phil Turnbull

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