Shorting Italy - Too big to fail, too big to bail, and definitely too big to ignore.

By: Aaron Fennell
Date: November 16, 2011

The current European sovereign debt crisis has been developing for a number of years. The situation is still moving in a negative direction and many of the countries in question have failed to make meaningful changes to their fiscal imbalance. It is important that investors and traders consider the likely outcomes even when they are undesirable so that they can find the tools to position correctly for the difficult outcome.

In recent months traders and market commentators have been turning their attention from Greece towards Italy. Italy is essentially in a similar position to that of Greece two years ago. The debt to GDP ratio is over 120%, the 10 year interest rate is steadily climbing above 7.00%, the tax collection structures are ineffective, and there is significant political infighting about the appropriate course of action. The major difference between Italy and Greece is the shear size of the Italian economy. Italy is a G8 country with significant economic importance in Europe. Italy is the forth largest economy in Europe and the eighth largest in the world. Greece has also provided the roadmap for an unravelling European economy. Markets have seen the outcome of a futile effort to turn around a fiscal imbalance. Italy may unravel much faster than what was observed in Greece as the markets enforce austerity. Two years ago it seemed impossible that a developed country could have a sovereign debt default. Today, it not only seems possible but it actually appears likely for many developed countries.

The implications of an Italian sovereign debt crisis are far reaching and unpredictable. It is impossible to know all of the implications for contagion for investors in North America or other global markets, but we live in an extremely integrated global economy. Capital knows no borders so the consequences of economic catastrophe quickly spread to every corner of the free world. Default in Italy could cause significant upheaval for investors in Canada who have little direct exposure to Italy. Traders and investors cannot afford to stand by or fail to act in protecting themselves from an Italian sovereign debt default.

It is generally good practise for traders to address economic situations with the most direct tools available. There are two benchmark futures contracts available to trade the Italian economy. The FTSE/MIB index futures are used to trade the Italian equities markets and the Euro BTP 10 Year futures trade based on the long term Italian interest rates. There is no question that these benchmarks have already started moving in the negative direction, but a sovereign debt default would likely have catastrophic impacts on both of these benchmarks.

On the equity side of things one could consider shorting the equity index futures either outright or as a spread against other healthier equity indices such as the German DAX or the S&P 500. On the fixed income side shorting the Euro BTP would directly respond to rising Italian interest rates. Of course if the Italian government some how manages to turn around the challenging situation through austerity measures or more effective tax strategies it is certainly possible that both the MIB and the Euro BTP could move upwards. There are risks to every strategy. However, the greatest risk comes from being uninformed and responding with inaction.

One can see the contract specifications and index composition for the FTSE/MIB regular and mini sizes contracts as well as the Euro BTP 10 Year futures through the following links.

FTSE MIB Composition

MIB

Mini MIB

Euro BTP 10 Year

The Fennell Thompson Group can facilitate transactions in the MIB futures and the Euro BTP 10 Year futures as well as most other European futures contracts. If you would like to establish a strategy to react to the developing situation in Europe then please contact the Fennell Thompson Group by phone at 416-862-3945, via email at FTGroup@ScotiaMcLeod.com, or through http://www.fennellthompson.ca/.

Disclaimer: Opinions expressed are subject to change without notice. This report should not be construed as a request to engage in any transaction involving the purchase and sale of a futures contract and/or commodity options thereon. The risk of loss in trading futures contracts or commodity options can be substantial, and investors should carefully consider the inherent risks of such an investment in light of their financial condition.