I have spoken before about buying 5y German CDS @ 40bps and still like the idea very much.
Since this bet could take sometime to pay off there is another way to work on this trade which is the steepener.
What are the downsides on the outright long German 5y CDS:
1. Its price going down, of course, out of a 5y duration
2. The play going nowhere for quite sometime and you having to disburse the insurance premium of 40bps/year (which is cheap)
So if you do not like (2) above, as this fight is against policy makers, banks, socialist-capitalism (that transfers bank losses to tax payers), because we do not know WHEN it could actually work selling 2y German protection as a source of funding might look interesting.
Live market prices now are:
2y German CDS: bid @ 17bp
5y German CDS: offer @ 46bp
You do it duration weighted:
Sell 50m 2y @ 17 = receiving 85k USD/year
Buy 20m 5y @ 46 = paying 92k USD/year
Net cost, per year = 7k USD.
Catastrophe Scenario
- Germany defaults overnight: net exposure is 30m USD (50m short x 20m long)
Probability: very low as the German fiscal situation is 'healthy'. Their debt levels are low, their ongoing fiscal gap is reasonable and activity, even though super leveraged to global trade/exports, is very good.
What could change: Greece defaults and german banks get wiped out and global trade comes to a halt
What is bad: they have Euros and they can't print Euros like the US or Japan can, really fast.
My point is: if this Catastrophe Scenario happened overnight YES, the trade would get crushed and the risk-reward would be ridiculously bad.
BUT I really do not think this would happen overnight and things would deteriorate gradually giving us time to exit the trade
An unlikely scenario, but more likely then german default scenario, is things get sour quickly and the German curves goes inverted way too fast.. Two-year spreads go up faster than the 5y-spreads. That is a stop-loss even though you believe the fundamentals backing the trade are sound.
What could make this scenario dangerous is the fact that 2y German CDS spreads are way too low in absolute terms. That's 17bps. Someone who wants to put in their books catastrophe-like hedges that are extremely cheap.. could just outright buy these 1y or 2y babies. This actually bothers me, making me like the 5y-outright-long a lot.
So what is the most-likely scenario in my opinion:
Things keep on deteriorating despite all the talk of "we're OK" from policy makers.
Italian and Spanish sovereign debt goes bad... and slowly Germany is brought into the mess to save everyone else, alongside with France, backing all these packages.
French CDS have already gone a bit wild. It came from sub-70bps to almost 90bps and the same 2y/5y steepener traded at 35 and is now above 50bp levels.
Sounds like a pattern to me. Sounds interesting.
Since this bet could take sometime to pay off there is another way to work on this trade which is the steepener.
What are the downsides on the outright long German 5y CDS:
1. Its price going down, of course, out of a 5y duration
2. The play going nowhere for quite sometime and you having to disburse the insurance premium of 40bps/year (which is cheap)
So if you do not like (2) above, as this fight is against policy makers, banks, socialist-capitalism (that transfers bank losses to tax payers), because we do not know WHEN it could actually work selling 2y German protection as a source of funding might look interesting.
Live market prices now are:
2y German CDS: bid @ 17bp
5y German CDS: offer @ 46bp
You do it duration weighted:
Sell 50m 2y @ 17 = receiving 85k USD/year
Buy 20m 5y @ 46 = paying 92k USD/year
Net cost, per year = 7k USD.
Catastrophe Scenario
- Germany defaults overnight: net exposure is 30m USD (50m short x 20m long)
Probability: very low as the German fiscal situation is 'healthy'. Their debt levels are low, their ongoing fiscal gap is reasonable and activity, even though super leveraged to global trade/exports, is very good.
What could change: Greece defaults and german banks get wiped out and global trade comes to a halt
What is bad: they have Euros and they can't print Euros like the US or Japan can, really fast.
My point is: if this Catastrophe Scenario happened overnight YES, the trade would get crushed and the risk-reward would be ridiculously bad.
BUT I really do not think this would happen overnight and things would deteriorate gradually giving us time to exit the trade
An unlikely scenario, but more likely then german default scenario, is things get sour quickly and the German curves goes inverted way too fast.. Two-year spreads go up faster than the 5y-spreads. That is a stop-loss even though you believe the fundamentals backing the trade are sound.
What could make this scenario dangerous is the fact that 2y German CDS spreads are way too low in absolute terms. That's 17bps. Someone who wants to put in their books catastrophe-like hedges that are extremely cheap.. could just outright buy these 1y or 2y babies. This actually bothers me, making me like the 5y-outright-long a lot.
So what is the most-likely scenario in my opinion:
Things keep on deteriorating despite all the talk of "we're OK" from policy makers.
Italian and Spanish sovereign debt goes bad... and slowly Germany is brought into the mess to save everyone else, alongside with France, backing all these packages.
French CDS have already gone a bit wild. It came from sub-70bps to almost 90bps and the same 2y/5y steepener traded at 35 and is now above 50bp levels.
Sounds like a pattern to me. Sounds interesting.
*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
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