Italy's challenge

As we all know very well, yields on Italian bonds surged dramatically this year. This represents a huge problem for an economy that has debt levels currently around 125% of GDP, because of the increased cost the government incurres in financing its debt. You can imagine what this means in terms of money loss, given the fact that the sovereign has a public debt that amounts to €1.9 trillion. Take a look at this chart.



Recently there has been discussion about the fact that yields would have gone even higher had the ECB not been buying large quantities of Italian debt. This is something very disturbing because it tells just how much global investors have lost confidence in Italy's ability to serve its debt. All of a sudden people are percieving Italy as much riskier than they used to.  So I asked myself: why is this happening? Why all of a sudden there is a lack of confidence in my countries' capability to remain solvent?

If we look at the Italian bond yield chart and we listen to what the news suggests (the English media in particular) we might come to the conclusion that this is the result of a sudden and unexpected problem. One might argue that bond yields surged this much because of uncertainty about the future of the Eurozone due to the bad financial situation that certain Eurozone sovereigns are facing. Although this factor was definitely one of the causes, I believe that it is not the only one. The problems are many and they are not only financial, but there are also political and social causes behind Italy's problems. Eventually all of this ended with Italy "losing its face" in the global environment because of media magnate Silvio Berlusconi's ackwardness and excessive italian-style humor that wasnt understood by the International press and political world, came at a wrong time and from the wrong person (you cant be a prime minister and a jester at the same time, even though it worked out to hook up the Italian voters) (Apparently).  =P

Other causes that lead to he current situation are excessive legislative bureaucracy, which serves as an obstacle to the much needed FDI by slowing processes and "social division" between sustainers of Berlusconi and sustainers of the opposition, the socialist party, with the result of a country that isnt united, a problem for the country both at a national and international level.  In the last elections Berlusconi won by a handful of votes. Almost half of the population wasnt happy with the previous ruling political party. This might be one of the causes of another major problem that Italy is facing, i.e. the loss in competitiveness of Italian firms in the global market. Eventually Berlusconi had to resign.

The new PM, Mario Monti, is the dean of Italy's most prominent economics university, an expert in economics and the financial markets.

I think that because the most important goal that Italy has to achieve  right now is to lower its borrowing cost it is crucial that investors re-gain confidence in the Italian market and start re-buying Italian debt. The current yield level on 10yr bonds is unsustainable in the long term. Just think that an auction on November 29th commanded a 7.89% return on three-year bonds!

The appointment of a technocratic government was a first step towards the solution. Now it is up to Monti and his government to convince the markets further by imposing much needed austerity measures that will make him extremely unpopular in Italy but might be the only way to save Italy and Europe from the disaster that a breakout of the Eurozone would lead to in terms of GDP, real incomes, unemployment and inflation.

CDS explained part 2. Why are they important to us??

The main goal of credit default markets is to establish market prices for a given default risk. As in all other markets, the market price of a CDS is established based on on the law of supply and demand.

The credit default swap market plays a huge role in financial speculation nowadays. Depending on how risky (depending on the possibility of bankrupcy or possibility of default on debt) investors percieve a sovereign to be, they will decide if they want to bet in its favour, insuring its solvency, i.e. sell protection on a CDS (and thus recieving premiums)  or bet against it, buying protection, thus paying the periodical premium (because they expect a credit event to happen, which mean that they would recieved the notional amount specified on the contract (usually $10million).

The rate of payments made per year by the buyer is known as the CDS spread. If there are more buyers than sellers in the market, the spread widens, meaning that it will cost more to buy protection on that particular CDS. 100 basis points equal a 1% interest.

Now lets look at what are known as the CDS market "hot charts" on sovereign debt:

These charts above have been the source of all these rumours we have been hearing from friends, we have been reading on facebook, twitter, and now even in the news! (meaning its now no more a taboo to talk about it!) about a possibility of a collapse of the eurozone.



Did he just say it? Yes- I said it. What these charts mean is that more and more speculators are buying protection on these sovereigns and less are selling it- meaning that more people are expecting a credit event to occur. For example right now someone buying protection on italy has to pay 5.5% interest per year on the notional amount of a contract to the seller of insurance. If, for example, the notional amount of a contract is $10million, the buyer will have to pay $550000 per annum to the seller in interests until maturity. Should the pre-specified credit event occur, however, the seller of protection deliveres to the buyer of the CDS the notional amount of the contract, $10million in exchange.

The reason why the credit default swap market is so important to international investors and expecially to sovereigns is because of the very high correlation that credit defaults swap spreads have with sovereign bond yields. Just look at these charts:

It is apparent even to the eye of someone who knows nothing about finance and economics that CDS on and bonds issued by the same sovereign follow very much the same trend, with moves in the CDS market often actually anticipating moves in the bond market. (Palladini G., Portes R., 2011)

Therefore investors holding sovereign bonds issued by troubled economies (such as the piigs) or speculators willing to enter this high-risk (but also with high profit potential) trade should always keep an eye on the CDS markets, to try to anticipate market moves and be able to act on their credit risk exposure to these economies.

CDS explained part 1. What are credit default swaps??

Since the collapse of Lehmann Brothers on the 15th of September 2008, we have been hearing increasingly more about credit default swaps. But what exaclty are these?

A credit default swap is conceptually a sort of insurance. The way a CDS works is really simple. First of all, whoever buys a CDS is buying an insurance on something. The buyer of insurance then pays a premium (interest) to the seller of protection periodically. In the case a credit event should occur, which is a pre-specified event that triggers the default of the contract, the seller of insurance has to deliver the notional amount specified on the contract to the buyer of protection in exchange for the underlying credit asset. This is the ONLY case in which the CDS seller pays the buyer. If a credit event does not occur, the contract expires at maturity.

The underlying assets on a CDS contract may vary. They are typically governments and corporations bonds, but they might include any financial instrument or index for which someone might want to buy protection, and for which someone might to sell it.

In the case that solvency of a sovereign or of an institution is being insured, the credit event is typically triggered by bankrupcy, but credit events might refer to a variety of other events, depending on the contract. Examples of other sources of credit event can be the downgrading of a credit rating, a fall in index level or share price, or even an natural disaster, such as a tsunami or an earthquake.

The only difference with traditional insurance is that the buyer of protection does not need to actually own the underlying asset.

Thus CDS are very flexible instruments that can be useful to the purpose of risk management. But how are they priced? As your intuition might suggest, they are traded openly and they have fluctuating prices. In the case that the underlying asset is a sovereing bond, the main fundamental factors used to assess the credit quality of the sovereing issuer are: the budget deficit, the debt-to-GDP ratio and the current account. (Criado, S. et al. 2010)

For further clarification of what these financial instruments are, follow this link:

http://www.youtube.com/watch?v=jHVnEBw93EA

Global commodity price inflation and food prices

A commodity price index is a tipical indicator used to calculate changes in inflation. It is a weighted average of selected commodity prices. These commodities are usually taken from different categories of goods, such as energy, metals and agricultural goods. Here is a tipical commodity chart:

By looking at it it is clear that  prices of goods have increased dramatically in the last 20 years.













Now let's focus just on food prices. It shows that most agricultural goods have increased in price since by almost 60 % from 2006 to 2008. (Trostle, R. 2008). http://www.ers.usda.gov/Publications/WRS0801/WRS0801.pdf
We can deduce that agricultural commodities were among those goods that pushed prices up.

So what is the reason for the dramatic food price increase starting in 2006 up to 2011? The law of supply&demand would have us believe that people were buying much more than they were selling, but was this really the case?

Reasearch from the U.S. department of agriculture shows that there were many possible causes that could have led to food price inflation. Population and economic growth, rising per capita meat consumption (which in turn pushes up the price of wheat or other agricultural commodities used to feed animals), slowing growth in agricultural production, rapid expansion in biofuels production, dollar devaluation and rising production costs are among the most commonly accepted factors driving up prices.

The problem with this is that it fuells speculation-as investors expect prices to rise in the future, they buy commodity futures and this pushes prices up even more. So the result is that that speculators worsen a situation that is already dangerous. Just think about the consequence that such a food price inflation has on people living in thirld world and developing countries.