Today, I was wondering how much of tail risk is priced in the market at the moment. EURUSD currency pair provides one of the purest way of trading a potential Euro Zone breakup, while European stocks are my natural
underlying (because of my job).
Tail risk is cheap on a 5 year
relative basis in FX and damn cheap in equities.
- EURUSD: 6M 25D Butterfly:
Currently in 24th percentile on 5Y history
- Eurostoxx 50:
- 6M Put Skew (90%-100%)
currently in 9th percentile on 5Y history
- 6M Call Skew (100%-110%)
currently in 7th percentile on 5Y history
Most of the person I talk to
believe that the probability of a breakup of the euro through exit of Greece is non-negligible. Some of them even consider as pretty much already done. So I have a hard time reconciling the idea of a Euro break up (a true tail risk event, from my view) and low implied
volatility.
Indeed, it is not very clear how a
country can leave (or be forced to leave) the eurozone from a legal and
practical point of view. We have a very interesting paper which won the Wolfson
Prize on this topic, stating that ‘Overall, () analysis has revealed a series
of very tricky issues which any exiting country would need to face” “but all of
these difficulties can be overcome”.
In Summary, a country, such as
Greece, contemplating leaving the euro would have to keep its plans secret
until the last minute, introduce capital controls, start printing a new
currency only after formal exit, implement last-minute bank holidays, seek a
large depreciation (30/50%), default on its debts (note: redomination of debt
may not automatically lead to default as it depends on lex monetae and
contractual intentions, especially for countries that have issued debt under
domestic law), recapitalise bust banks and seek close co-operation with remaining
euro members.
“Such a rebalancing of the economy
away from reliance on net exports would be in the interests of the whole of the
current membership of the eurozone, as well as countries outside it,” according
to the paper. Nice.
Moreover, an exit also means heavy losses
for debt holders as debt is likely to be re-denominated in the depreciated new
currency. One-Off public costs of a euro area exit for European counterparts of
Greece (from The Economist) in Eur would be 323bn:
- Aid package 50bn
- Disbursements in bails
outs 127bn
- Govt bonds held by ECB 40bn
- Target2 debt 106bn
Talking about tail risk, I found an
interesting note by Bank of America-Merrill Lynch on game theory and euro breakup risk premium published
in July12. It explains that an uncooperative outcome dominates the strategies
of both Germany and Greece (this is why we are stuck for the last 2 years).
The paper also explains that in looking at output growth, borrowing cost,
balance sheet impacts, Italy and Ireland are the two countries benefiting most
from a voluntary exit of euro. Germany, despite being the most likely to leave,
has the lowest incentive to do so due to negative impact on growth and loss
from debt holding. So the game of Germany would be to ‘bribe’ Italy to stay.
However, the Nash equilibrium of
the game would be an exit of Italy regardless of what Germany does. This sounds
a bit extreme. However, I try to keep in mind that the world is much more
violent than what we would like to think and outcomes much more volatile than
predicted in our models.
So I do not understand why tail
risk is currently priced so low, if we consider the implications of a euro break up: sorting out the uncertainties and taking the losses.
The only thing I can think about is
QE and/or a weaker Euro… A recent survey of fund managers showed that 80% of
fund managers see ECB doing QE in Q3/Q4. So SX5E Call Spreads are really cheap
then?
References
http://www.economist.com/node/21560252
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