Sovereign Credit default swaps

Sovereign Credit default swaps February 19/ 2011:

Sovereign Credit default swaps February 19/ 2011 The Infamous Greek Debt Fiasco - Ioannis Logothetis

Why Greece, why now? :

Why Greece, why now? Weak economic fundamentals High debt High deficit (exceeding the Euro area 3% target) Substantial funding needs Market financing costs have skyrocketed Questions about debt sustainability Upcoming redemp t ions are significant Social unrest due to the austerity measures Very low c ompetitiveness

Debt Levels relative to GDP:

Debt Levels relative to GDP

Credit spreads:

Credit spreads

Credit spreads:

Credit spreads

Debt Unsustainability:

Debt Unsustainability R eal GDP Growth : -2%(2009), -4.8% (2010) Unemployment : 14%(2010) Debt growth: more than 16% (IMF/EU bailout, additional treasur y auctions) Government Revenue : 36% of GDP (2009) Govern m en t E xpenditure: 50% of GDP (2009) Government Deficit : 13.6% of GDP (2009) In 2013 , national debt is estimated to reach 160%(of GDP) N ominal economic growth < average interest growth on the debt ‘ D ebt to GDP’ ratio highly unsustainable .

Debt Unsustainability:

Debt Unsustainability

Debt restructuring:

Debt restructuring The lowe r the credit rating o n a bond , the high er its yield and its CDS premium . CDS premiums and high bond yields are reflecting high probabilities of sovereign default After the IMF/EU bailout , a haircut is likely to happen for the 2012 maturing debt. A haircut of more than 40% should happen in order to bring the debt ratio to a sustainable level.

CDS premiums:

CDS premiums

CDS - profit & loss:

CDS - profit & loss Purcha s ing CDS contracts for 10 year government bonds CDS premium for 10 year government bonds: 867.8bp (minimu m insurance for € 1 0million) Protection for €20million would cost: € 867,805 * 2 = €1,735,610 each year.

CDS - profit & loss:

CDS - profit & loss The best case scenario : Greek government and the EU authorities anouncing a 45-50% haircut in government bonds maturing in 2012: An investment of €1,735,610 will give a return: 0.45*20m = € 9,000,000 Risk exposure: Greece will anounce a haircut in 2013, thus a premium has to paid for 2013 as well. Return : € 9,000,000 - (1,735,610 *2) = € 5,528,780 The worst case scenario : Haircut will be around 20 - 30% and will be anounced in 2013 th us the return is smaller: 0.25*20m = 5000000 - (1,735,610 *2) = € 1,528,780 Stop Loss: If by 2013 , Greece does not a n nounce a debt haircut, then we could end the CDS contract to minimize our losses at : € 3,471,220 Opportunities are there to be exploited, depending on the seriousness of Papandreou’s government in applying the IMF and EU’s stipulations , one shouldn’t be too wary of these Greek’s bearing gifts.

References:

References http://www.oecd.org Reuters 3000 xtra F inancial Times Mussa M . (2010), Beware of Greeks Bearing Debts , Peterson Institute for International Economics Tavakoli M. (2001), Credit Derivatives , John Wiley & Sons Inc , Canada Nomura (2004), Credit default swaps (CDS) primer . Fixed income research , Tokyo