1.Explain what a credit default swap is, and how it is generally used.

2. How is the CDS market behaving in Europe with the approaching French elections? Explain why there is more than one type of CDS being traded, making reference to the WSJ article The perfect Frexit Trade? Credit-Default Swaps.

Article:

Investors looking to insure

themselves against the risks

of the French election are

turning to a derivative long loathed by Eu

ropean politicians: credit default swaps.

French CDS trading volumes have rocketed in

recent weeks as far-right candidate Marine

Le Pen gains in polls ahead of th

e spring presidential election.

Ms. Le Pen favors pulling her country out

of the euroa scenar

io that lawyers and

analysts say could trigger payouts on some CD

S contracts that insure

trillions of euros

worth of French government and corporate debt.

This copy is for your personal, non-commercial use only. To orde

r presentation-ready copies for distribution to your colleagues

, clients or customers visit

http://www.djreprints.com.

https://www.wsj.com/articles/french-credit-de

fault-swap-trading-vol

umes-surge-1487787868

MARKETS CREDIT MARKETS

The Perfect Frexit Trade? Credit-

Default Swaps

French credit-default sw

ap trading volumes surge following Marine Le

Pens gains in election polls

|

A woman taking a dog for a walk passes by a poster for fa

r-right French presidential el

ection candidate Marine Le

Pen in Marseille, France.

PHOTO: BORIS HORVAT/AGENCE

FRANCE-PRESSE/GETTY IMAGES

Feb. 22, 2017 1:24 p.m. ET

By CHRISTOPHER WHITTALL

Page 1 of 5

The Perfect Frexit Trade?

Credit-Default Swaps - WS

J

The election has already roiled European bond

markets, sending the yields on the debt of

France and weaker eurozone economies much higher.

Now, it is being felt in the CDS market, which

local politicians tried to curb in 2012 amid

concerns that it was fueling instability

during the European sovereign-debt crisis.

The CDS market insures

against French bonds

defaulting, but it has also

become a way to take a

position on a specific risk

posed by a Le Pen

victory: France dropping

the euro.

That is due to a quirk of

how CDS contracts were

rewritten, following the

debt crisis, to take into

account a potential

eurozone breakup. Now

two types of CDS trade

side by side: one contract

that analysts say is likely

to protect investors if

France took a new

currency, and one that

they say may not.

Before Christmas, we

thought the risk of Le

Pen was not properly

priced into markets. We thought the best wa

y to play this was through short-dated CDS,

said Vassilis Paschopoulos, a

portfolio manager at London

-based investment manager

Numen Capital.

Page 2 of 5

The Perfect Frexit Trade?

Credit-Default Swaps - WS

J

A

n average of $784 million of CDS that insu

res against a French sovereign default has

traded a week since early January, accord

ing to data from the Depository Trust &

Clearing Corp. That is up from a weekly av

erage of $378 million in 2016, according to

Citigroup Inc.

The annual cost of insuring against a defaul

t for five years on $10 million of French

government debt was $71,000 on Wednesday,

up from $38,000 at th

e start of the year,

according to IHS Markit, as concerns over

Ms. Le Pen winning the election have grown.

To be sure, most polls and French commentator

s believe that Ms. Le Pen wont win. Even

if she does, there would be many hurdles to leaving the euro.

But after being surprised by Brexit and Donald

Trumps election victory, some investors

are protecting themselves from the risk.

Trading in CDS has resurfaced

a question that has plagued the eurozone since the debt

crisis. How do you take into a

ccount the risk of an event for

which there is no blueprint: a

country dropping out of the euro.

Legal documentation that governs CDS chan

ged in 2014. Among other things, those

changes looked to account for the risk of a

country, particularly th

ose from the eurozone,

adopting a new currency. The change came afte

r the sovereign-debt crisis highlighted the

risk of countries dropping out of the euro

, something that nearly happened with Greece.

Contracts that lawyers say ar

e less likely to ca

pture this risk, and are based around

language written in 2003, still trade alongs

ide those that came after the 2014 redraft.

The 2003 legal definitions state that conver

ting debt into a currency belonging to a

Group of Seven nation, of which France is

one, wont trigger a payout on CDS.

The 2014 contracts state that co

nverting debt into a currency

other than those of Canada,

Japan, Switzerland, the U.K., the U.S. and

the euro could trigger a credit event if a

b

ondholder takes a hit on the value of

their holdings, among other criteria.

While there is still debate, most analysts ag

ree the 2014 contracts

should provide more

protection for investors.That discrepancy potentially opens up an arbitrage opportunity

b

ecause it has made the more recent contracts more valuable.

The 2003 definitions were written when the

future of the euro was

not in doubt, said

Saul Doctor, a credit stra

tegist at J.P. Morgan.

Page 3 of 5

The Perfect Frexit Trade?

Credit-Default Swaps - WS

J

A

s of Tuesdays close, it cost about $21,000 more a year to buy credit protection using

the 2014 contracts over the 2003 contracts,

according to IHS Ma

rkit. At the end of

January, it cost in

vestors $3,000 more.

Some investors, though, aren

t convinced by this trade.

London-based hedge fund PVE

Capital believes that a chaotic French exit

from the euro would probably trigger both

contracts.

Were not a big fan of the trade,

said Gennaro Pucci, PVEs founder.

But others say investors shouldnt take it for granted that they will be able to claim on

their CDS.

If there is a freely traded exchange rate

between euros and a new

French currency, and

converting bonds into that cu

rrency doesnt incur a loss, then the contracts may not be

triggered, said Edmund Parker, global head of

the derivatives practice at law-firm Mayer

Brown.

We are looking at a range of possible outc

omes, from large amounts of French CDS

triggering to no effect at all, Mr. Parker said.

Taking into account su

ch outcomes could be essential for those looking to use CDS to

hedge against what they see as the risks of Le Pen victory.

There is roughly 2 trillion ($

2.11 trillion) of French public debt under French law that

could be redenominated into a new currency if

Paris pulled out of the euro, according to

Citigroup. There is also around 240 billion

of French corporate debt, and around 340

b

illion of French financial de

bt, J.P. Morgan calculates.

Theres no actual stipulation as to how a

country could go about

leaving the eurozone,

said Aritra Banerjee, a strategist at

Citigroup. Its completely untested.