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BREXITANDITSQUANTIFICATIONONGBPUSD

TheUnitedKingdomissettoholdareferendumonitsEuropeanUnionmembershipon23rdJune,2016.The referendum is taking placedue to the notion that EU rules and regulations are holding back theprogress of Britain. The scenario in which Britain leaves the EU membership is popularly termed as“Brexit”.

ArgumentsagainstEUMembershipare:

• Theprincipleof“freemovement”whichentailsthatresidentsofoneEUcountrydonotrequirea visa to visit another. British citizens feel that exiting the EU, and not being bound by “freemovement” will help the country keep checks on migrations, and prevent immigrants fromtakingawayjobopportunitiesfromthelocalpopulace

• Multiplerulesandrestrictionswhichhamperbusinessinthecountry• The EU charges many billions in annual membership fees. Some politicians claim that UK’s

membershipfeeis£55mnaday.(£20.0bnayear)

ProbablenegativeconsequencesofBrexit:

• IfUKvotestoleave,therewillbeasignificantuncertaintythatcouldtriggerasharpcorrectionofUK’slargeimbalances

• UK’s separation from EUmay lead to inflation in imports,whichmay further reduce the realincome.Thiswouldhaverecessionaryrisksandcouldcauseeconomicshockssuchas loweringofhousepricesupto10%1

• This can cause significant changes in thebank rates aswell, requiring theBankof England tofurther cut bank rates. The base rate is currently at 0.50%.Negative rates are a possibility ifBrexitoccurs

Whatever be outcomeof the referendum, the Poundwillmost likely be impacted. In fact, theBrexituncertaintyhasbeenamajordriverofG10FXmarketssincePrimeMinisterDavidCameronannouncedthereferendumdate.

Historically,GBP short positions tend to increase before votes in either general elections or before areferendum.Whiletheshorttermimpacthasacertaintrend,themedium-termimpactofpoliticaleventrisksonGBPismuchlessclear.Infact,incaseUKvotestoleave,anunwillingnessofexternalinvestorstofinancethecurrentaccountcouldcauseacollapseinthecurrencyof10%-15%overseveralmonths.1Portfoliomanagersbelievethattheprobabilityofthisscenarioisaround33%.2

On the other hand, if UK choses to stay with the EU (“Bremain”), market uncertainty will reducesignificantly.AsmallriseintheUKbondyieldsandariseintheglobalequitypricesisexpectedtofollow.The rate cut expectations fromBank of Englandwill be lowered,whichwill lead toGBP appreciatingagainstG10currencies.Theprobabilityofthisscenariois67%.2

To understand the impact of Brexit on UK, one can look at the currency market. A suitable pair toconsideristheGBPUSD.First,welookattheimpliedvolatilityinthepair.Impliedvolatilityisobtained

23June2016 2bylookingatthepremiumofat-the-moneyoptions(optionswhichhavetheirstrikepriceequaltothespotprice)andthenusingtheBlack-Scholesmodeltoobtainthevolatilityatwhichthepriceofsuchanoptionwillbeequaltothecurrentprice.

DataSource:Bloomberg

The implied volatility has shot up to almost 20% as the referendum date is approaching. Impliedvolatility is considered a “fear gauge”.When there is fear in themarket, investors try to hedge theirpositions by purchasing options, which increases the premium paid for the options. This in turnincreasestheimpliedvolatility.Next,welookatthecostofastraddlestrategyonthispair.

Source:Bloomberg

5%

8%

10%

13%

15%

18%

20%

Jun2013 Dec2013 Jun2014 Dec2014 Jun2015 Dec2015 Jun2016

ImpliedVolaelityofGBPUSD

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Here, using the BloombergOptions Valuation Tool (OVML), a straddle strategy forGBPUSDhas beenpriced, where a GBP call as well as GBP put is purchased. Hence, if the currencymoves beyond thepremium paid for both the call and put options, this strategy proves to be profitable. In percentageterms, the price of this strategy is approximately 880 pips (0.088%). Hence, it can be concluded themarketparticipantsexpectthatintheeventofaBritishvotetoquittheEU,GBPUSDwoulddropatleast880pips(or$0.088)overthenextmonth.

Wewillnow lookata risk reversalmeasure.The risk reversalmeasuregivesan indicationas towhatwould be the cost of an unexpected outcome in the straddle strategy. Risk reversal represents thedifference in the implied volatility between the 25-delta call and the 25-delta put for a currency. ForGBPUSD, therisk reversalat -5.36%showsthatoptionsmarketparticipantsexpectaspike in IV,evenfromcurrentelevatedlevels.

Source:Bloomberg

Sources:

1) NomuraResearch–BrexitCarriesaRecessionaryRisk2) BankofAmericaMerillLynchsurvey-Forbes