By Christopher Whittall 

Investors looking to insure themselves against the risks of the French election are turning to a derivative long loathed by European 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 the spring presidential election.

Ms. Le Pen favors pulling her country out of the euro -- a scenario that lawyers and analysts say could trigger payouts on some CDS contracts that insure trillions of euros-worth of French government and corporate debt.

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 way to play this was through short-dated CDS," said Vassilis Paschopoulos, a portfolio manager at London-based investment manager Numen Capital.

An average of $784 million of CDS that insures against a French sovereign default has traded a week since early January, according to data from the Depository Trust & Clearing Corp. That is up from a weekly average of $378 million in 2016, according to Citigroup Inc.

The annual cost of insuring against a default for five years on $10 million of French government debt was $71,000 on Wednesday, up from $38,000 at the 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 commentators believe that Ms. Le Pen won't win. Even if she does, there would be many hurdles to leaving the euro.

But after being surprised by Brexit and Donald Trump's election victory, some investors are protecting themselves from the risk.

And trading in CDS has resurfaced a question that has plagued the eurozone since the debt crisis. How do you take into account the risk of an event for which there is no blueprint: a country dropping out of the euro.

Legal documentation that governs CDS changed in 2014. Among other things, those changes looked to take into account the risk of a country, particularly those from the eurozone, adopting a new currency. The change came after the sovereign-debt crisis highlighted the risk of countries dropping out of the euro, something that nearly happened with Greece.

Contracts that lawyers say are less likely to capture this risk, and are based around language written in 2003, still trade alongside those that came after the 2014 redraft.

The 2003 legal definitions state that converting debt into a currency belonging to a Group of Seven nation, of which France is one, won't trigger a payout on CDS.

The 2014 contracts state that converting 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 bondholder takes a hit on the value of their holdings, among other criteria.

While there is still debate, most analysts agree the 2014 contracts should provide more protection for investors.That discrepancy potentially opens up an arbitrage opportunity because 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 strategist at J.P. Morgan.

It currently costs $21,000 more a year to buy credit protection using the 2014 contracts over the 2003 contracts, according to IHS Markit. At the end of January, it cost investors $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.

"We're not a big fan of the trade," said Gennaro Pucci, PVE's founder.

But others say investors shouldn't 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 currency doesn't 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 outcomes," from large amounts of French CDS triggering to no effect at all, Mr. Parker said.

Taking into account such 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 EUR2 trillion ($1.11 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 EUR240 billion of French corporate debt, and around EUR340 billion of French financial debt, J.P. Morgan calculates.

"There's no actual stipulation as to how a country could go about leaving the eurozone," said Aritra Banerjee, a strategist at Citigroup. "It's completely untested."

Write to Christopher Whittall at christopher.whittall@wsj.com

(END) Dow Jones Newswires

February 22, 2017 13:39 ET (18:39 GMT)