A lopsided trade is a good trade, Italian inflation edition

It turns out we were wrong on Monday when we suggested a good way to ~~profit~~ mitigate losses if Italy were to leave the euro, as we've since heard a much better idea: buy Italian inflation swaps.

Such swaps are contracts agreed over-the-counter with an investment bank. So the first step in this trade should be to find a French or American institution dubbed systemically important, to ensure they'll survive the financial convulsions should Italy to return to the lira.

Then enter into a five- or perhaps eight-year swap. The idea is to pay a regular fixed coupon, and to receive in return a floating payment tied to the level of consumer price inflation in Italy.

There are two important contractual points to keep in mind. The first is to ensure payments are denominated in euros, and the second is to include a provision that says the floating rate can't fall below zero even if consumer prices decline.

If Italy keeps the euro, the trade's downside should be relatively limited, since the worst-case scenario for the country involves a slide into depression and deflation. Of course, this is the reason for the floor mentioned above, because deflation would require two payments to a counterparty -- one of the fixed rate agreed upon at the start, and the other for the deflation rate. (The last time Italy's consumer prices declined for the year was back in... 2016, though just by 0.1 per cent.)

The trade really pays off, however, in a scenario where Italy redenominates. It seems safe to assume the value of the new lira will drop significantly, say to 70 cents on the euro. The price of imported goods would rise substantially, pushing up domestic inflation. See, for instance, the UK experience since the Brexit referendum.

There are also other inflationary pressures to consider, given the populist agenda of the new government. Aside from a boost to growth from higher government spending, previous economic reforms put in place mechanisms where unfunded spending increases can trigger automatic increases in consumption taxes, which would produce a temporary increase in inflation.

The payment in the swap depends upon an inflation rate, a percentage figure rather than a euro-denominated number, which means you would be receiving Italian inflation rates in European currency. It also might be helpful to devote some thought to which of the five possible Italian inflation indices is used for the trade. For example, one option surveys inflation experienced by employed households, which might reflect more (or perhaps less) of any changes in prices of foreign cars, Italy's biggest import. Even so, Italy also imports a lot of machinery and packaged medicine, so the broader national survey could be a better gauge.

Because such swaps are negotiated, prices on the Bloomberg screen may not be spot on. But as an indication, the fixed side of a five-year Italian inflation swap on Tuesday was a rate of 1.31 per cent, compared to 1.53 per cent for European inflation. In short, it costs more to receive European inflation than Italian.

The question then might be why banks are so willing to take the other side of the trade, when the risks appear remote but the effects are lopsided. The answer may be because they think in terms of models and basis points rather than worst-case scenarios. (It could also be possible that some traders decide not to push for a floating-rate floor.)