Italy has two sets of credit default swaps (CDS) in play. One set uses 2003 rules of credit events. The other uses rules from 2014 and later.

Under 2003 rules, repayment of Euro bond obligations in Lira may not constitute a credit event. Under newer rules, repayment in Lira would definitely constitute a credit event.

The difference between the two sets of CDS is one measure of redenomination risk.

Eurointelligence offers an interesting discussion of the setup.

Mediobanca’s Antonio Guglielmi has been focusing like no-one else on Italian redenomination risk, which on its own is an indicator that there are serious problems ahead for Italy and the eurozone. In his latest article, he makes an interesting analysis of how to measure this risk, and finds that the difference between the 2003 definition of a credit event for credit default swap and the 2014 definition as a good starting point.

The 2014 definition explicitly adds redenomination as a new criterion for a credit event. And it changed the list of re-denominable currencies from the currencies of the G7 countries to those of Canada, Japan, Switzerland, UK, US and the euro. This means that only redenomination into these currencies would not trigger a credit event. In other words, if Italy redenominates, it is a credit event under the 2014 definition but not (necessarily) under the 2003 definition. Now, both types of CDS are trading, so that the spread between the two serves as a good market measure of redenomination risks. He notes that, in the case of Italy, the rate for the 2014 CDS is 194bp while the rate for the 2003 type CDS is only 126 basis points. The gap of 68bp is thus a metric of the redenomination risk. This is not huge, but it is significantly higher than for France or Spain, and it has gone up in recent months.

We would like to add that as long as these risks are out there – in the sense that serious people are having serious discussions about them – there is no chance of normalization.

2014 CDS Mispriced Relative to 2003

The odds of redenomination in Italy are far greater than CDS would indicate. The only problem is timing it.

A possible play that I think would be an eventual winner would be a bet on redenomination under2014 rules and a bet against under 2003 rules. Such a play does require clarification that redenomination does not constitute a credit even under 2003 rules.

This is a sophisticated play for hedge funds to consider, nothing the average investor should attempt.

Nonetheless, I am quite certain the markets have underpriced redenomination risk, especially in relative terms.

Mike “Mish” Shedlock