Greece's debt problems are attracting hedge funds which are betting that the country will default. Meanwhile a leading German economist has argued that the European Central Bank should allow inflation to rise in a bid to avoid a costly and unpopular bailout for Greece. In recent weeks the funds have been dealing in so-called credit default swaps (CDS) on a large scale. A CDS is a contract under which one side pays an annual fee to buy protection against default, while the seller promises to cover losses in the event of a default. They are in effect an insurance policy against defaults of bonds and other debt. The buyer gets a payoff if the underlying bond goes into default.
In the case of Greece, the dealers in CDS are betting that the Greek government won't be able to repay its debts and that the price of CDS will therefore rise. The prices of credit default swaps on Greek sovereign debt have already reached astronomical levels, rising to a record high of 410 basis points last week, twice as high as in December. That means that investors who want to insure €10 million worth of Greek government debt against default for five years now have to pay around €400,000 a year. The equivalent hedging price for a German government bond amounts to just €35,000.
"It's the same game as a year ago with Austria," says Philip Gisdakis, credit analyst at Italian bank Unicredit. At the time, hedge funds benefited from rising CDS prices for Austrian debt. Austria's close economic ties with cash-strapped eastern European countries was regarded as a potential trigger for a government default.