Hedging Lessons from Brexit
On Thursday, British citizens will vote in a referendum posing this question – “Should the United Kingdom remain a member of the European Union or leave the European Union?” The result will have sweeping implications for trade policy, the flow of immigrants, and even the continued viability of the European Union. Hence, as the referendum’s projected outcome has shifted from Remain to Leave and back again, worldwide currency, interest rate, and equity markets have swung wildly.
As a global company with operations in the UK and Europe, we’ve been monitoring the referendum buildup closely. In addition to its anticipated economic and political impacts, there are also numerous valuable risk management lessons, including
(1) The best time to buy insurance: The cost of seasonal hurricane insurance on an Outer Banks home skyrockets once there’s already a Category Five hurricane heading up from the Caribbean. Similarly, as the anticipated probability of Brexit has increased, the cost of hedging the proceeds of a future sale of pounds sterling has risen tremendously. In fact, implied volatility – a main driver of option pricing – for short-dated GBP-USD options at certain strikes has more than doubled in the last week alone! The best time to have ensured the USD proceeds of a future GBP sale was when the amount and timing became sufficiently probable, rather than when the Leave campaign caught up to the Remain campaign in the polls.
(2) The non-symmetric nature of risk: As the referendum has approached, the cost of hedging GBP depreciation has become much more significant relative to GBP appreciation. Option traders use the phrase “volatility smile” to characterize how even or how skewed the relative costs of hedging depreciation versus appreciation can be – if the costs are relatively even, the volatility graph looks like a smile; if they are uneven, the volatility graph looks like a smirk, or even a black-diamond ski slope in extreme cases.
As an example, consider the 1-month GBP-USD volatility smile for June 2014, 2015, and 2016. In June 2014, there was nearly symmetrical appreciation and depreciation risk implied in options pricing for the pair, and the absolute level of volatility ranged from 4.8% to 5.6% (all charts from Bloomberg OVDV).
By June 2015, the volatility smile had become a smirk, with noticeably higher volatility (driving higher pricing) on the GBP depreciation side – the absolute level of volatility ranged between 8.5% and 10.5%.
Now look at June 2016. The ski slope has replaced the smile altogether, implying there is no point at which insuring against more depreciation is cheaper than insuring against more appreciation. Additionally, the absolute level of volatility is sky-high, ranging from 20% on the call side to a staggering 45% on the put side. Insuring against short-term GBP depreciation at this point will be astonishingly costly.
(3) The inter-related nature of markets: The buildup to the Brexit referendum has hit more than just pounds and gilts. The Euro has faced considerable downside pressure against the dollar, as markets fear contagion could spread to the common currency. Meanwhile, the Swiss franc continues its seemingly inexorable strengthening march, rendering its exports even more expensive everywhere else. And last week, the yield on the German 10-year bund, the effective benchmark bond of the European Union, turned negative for the first time in history. In other words, investors are willing to lose principal (over ten years!) for the perceived safety of German government issuances. Clearly, the pound is far from the only asset being affected by the upcoming vote.
(4) The relaxing nature of hedging: We have spoken with clients who reached out to voice concern about their sterling forward hedges maturing in the second half of 2016. It was a pleasure to tell those clients that – at least from the perspective of the economic exposures hedged by those specific forwards – they can relax during this referendum, because they are already hedged. Their sterling sales and dollar purchases will happen at the agreed-upon rates and amounts on the contracted dates, irrespective of the referendum’s outcome.
After years of anticipation, we’ll finally know this week if Britain is to leave the EU or to remain within it. If you have any questions about the risk management implications of Brexit, please don’t hesitate to give us a call, or meet us for a cup of tea.