June 21 (Bloomberg) -- The euro will fall 9 percent against the dollar should Greece default, according to Citigroup Inc. prices for quanto credit swaps that allow investors to bet on currency volatility and sovereign debt risk.
So-called quanto swaps on European government bonds give investors the chance to bet the 16-nation currency will decline as governments struggle to finance budget deficits. Profit can be made from buying insurance on a euro-area government in dollars and selling protection on the same bonds in the common currency, according to Citigroup.
“Everybody knows the euro will be punished if a country defaults, but nobody knows by how much,” said Mikhail Foux, a credit strategist at Citigroup in New York. Quanto credit-default swaps provide a “decent approximation,” he said.
An emergency ban on default swaps is being considered by the European Union after German Chancellor Angel Merkel and French President Nicolas Sarkozy blamed the derivatives for worsening the fiscal crisis. Germany curbed trading of some debt and euro-currency derivatives last month to ease selling pressure on the region’s bonds and currency.
Credit-default swaps signal there’s a 50 percent chance Greece will renege on its debt commitments within five years, according to CMA DataVision. Swaps pay the buyer face value less the value of the defaulted debt should a borrower fail to adhere to its obligations. The contracts allow investors to hedge against losses on debt or speculate on creditworthiness.
The euro may fall as much as 28 percent if France fails to repay investors, while a default by the Spanish government would trigger a 20 percent currency devaluation, Italy a 17 percent drop and Germany a 25 percent decline, according to Citigroup.
The euro has fallen 13 percent against the dollar this year and dropped to a four-year low of $1.1877 on June 7. At the same time, the Markit iTraxx SovX Western Europe Index of credit-default swaps on 15 governments surged to 168.5 basis points June 4, compared with 62.5 basis points Jan. 6, CMA prices show. “Investors who believe the current volatile environment is here to stay should be selling sovereign quanto CDS,” Foux said. “Quanto CDS is a great tool to mitigate one’s FX exposures.”
The impact of a sovereign default on the euro is calculated by the quanto spread, the gap between the cost of protecting against default in different currencies, divided by the benchmark credit-default swap level. Swaps on European sovereigns typically trade in dollars so the value of protection isn’t eroded by weakening of the euro in case of default.
The ratio between the Greek quanto, or the 75 basis-point difference between the cost of dollar- and euro-denominated swaps on the nation, and the cost of dollar swaps at 795 basis points is 9.4. Investors can profit from changes in spreads and currency as they rebalance their holdings and Citigroup said a quanto trade on Greece over the past six months would have yielded about 200 basis points.
The euro rose 0.5 percent to $1.2454 as of 8:04 a.m. in London. A basis point on a credit-default swap contract protecting $10 million of debt from default for five years is equivalent to $1,000 a year.
To contact the reporter on this story: Abigail Moses in London at Amoses5@bloomberg.net
To contact the editor responsible for this story: Paul Armstrong at Parmstrong10@bloomberg.net