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Citi Pushes FX, Credit Correlation Play

--Katy Burne

Citigroup is recommending investors take a view on fx spot movements and credit spreads while volatility and correlation between the asset classes is still relatively high by historical standards.

The firm is advising investors to use quanto credit default swaps, which are triggered for settlement if a borrower referenced in the contract suffers a credit event. Since the contract is an offsetting position for the same underlying, for example selling protection in euros but buying protection in U.S. dollars, the amount paid out will depend on whether fx spot rates have moved favorably in the relevant currencies from the inception of the contract. Holders also register mark-to-market gains on volatility movements and correlation between the underlying currency and credit.

Quanto CDS are quoted in terms of the differential between a standard CDS contract, for example on the current series of the CDX North America Investment Grade index, and the spread in the different currencies. A CDX protection contract, for instance, might be quoted at 84 basis points, but the quanto version would be quoted as -8bp in euros or -5bp in U.S. dollars. The net result is that a buyer pays 79bp (84bp-5bp) in euros to receive the U.S.

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