Hedge funds have been buying quanto credit default swaps on Spain over the last week to take advantage of agreements that obligate firms to buy back quanto CDS that they sold last year.
One London CDS trader said last year structuring desks at European firms agreed to make repurchasing agreements where they agreed to buy back their bonds and quanto credit default swaps one day before the bonds matured. Firms did this in order to keep the volatility off of their books while gaining yield.
The trader said three European firms have begun buying back quanto CDS on Spain in the last few days as part of the agreements, and hedge funds have been trying to take advantage of this. “Hedge funds are negative on Spain as a general rule,” the trader said. “We’re seeing a couple of hedge funds ride the coat tails and hang on.” The trades by hedge funds are between EUR50-100 million notional in size, a reversal from the illiquid market seen just a few weeks ago, the trader added.
Quanto CDS are denominated in euros but pay out in U.S. dollars should a credit event occur. Last week, hedge funds and CVA desks were buying quanto CDS on Spain to take advantage of perceived mispricing between the two currencies (DI, 4/09). The trader said that quanto CDS on Spain traded at 120 basis points, about 10 points tighter than last week. Representatives for Markit, which tracks CDS pricing, were not available.
