Brexit without the campaigning

By Damian Handzy | 13 June 2016

With all the spin surrounding the Brexit vote, it can be difficult to get a clear sense of the facts. The United Kingdom is about to make the historic and potentially seismic decision of whether to exit or remain a part of the European Union. Financial markets are providing signals of both the likelihood of a Brexit vote and its potential impact. This article is not about making an argument for or against the UK remaining in the EU and will not use historic precedents or fundamental trade analysis to argue about the impact of a ‘leave’ vote. Such analyses are more than readily available elsewhere. Instead we will structure a framework for understanding what type of immediate financial impact can be expected from a vote to remain and from a vote to leave. We have chosen to examine what today’s currency markets can tell us about the chances of a Brexit. Since such a decision would impact all financial portfolios, whether or not they are directly invested in European or UK securities, we formulated a series of market implied stress tests to help financial professions estimate the impact of a Brexit on their own funds.

The FX markets between the UK, EU and US provide a continuously traded high-volume data set that is deeply linked to a potential Brexit. While other factors, such as relative interest rates and GDP, certainly influence these markets, for the immediate future we believe they are dominated by traders’ evolving beliefs about the looming vote on June 23. We examined 2-month, 3-month and 6-month call and put quotes on GBP/USD, GBP/EUR and EUR/USD in late April. From the 25-delta and 10-delta volatility quotes, we extracted implied probabilities of movements in these three currencies under the two possible vote results: Exit and Remain. Bloomberg’s estimate of a market implied probability of a Brexit was about 30% in mid-April, consistent with the skew results we calculated from the FX option data.

Pound Sterling

The FX markets are clearly indicating that the Sterling stands to lose more in a Brexit than it stands to gain in a ‘Remain’ scenario, consistent with a built-in modest expectation that the vote will be to keep the EU intact. Today’s markets are signalling that a vote to stay would give an immediate pop to the GBP of around 3%, while vote for a Brexit would give an immediate plunge of 11%. Over the subsequent 4 months, the pound would either gain an addition 4% over the current spot or it would drop a further 3% for a cumulative loss of 14% against the already strong US dollar. Table 1 shows the ranges of likely movements in the GBP/USD rate following the vote. The numbers in the minimum columns have a 70% likelihood of exceeding the amounts shown, and the numbers in the maximum columns have a 90% likelihood of being below the stated numbers. For example, there is a 70% chance that the exchange rate would be above 1.491 at the end of June if the vote is to remain, while there is a 90% chance the rate would be below 1.404 at the end of June if the vote is to leave.

We performed the same analysis for EUR/USD and GBP/EUR over the same time periods and have summarized the 3-month points (end of July) in Table 2, shown below. In the event of a Brexit, we should expect the pound to lose against both the US dollar and the euro. We should also expect the euro to lose against the US dollar, and we should expect the pound to lose more against the dollar than the euro loses against the dollar. We believe that the correlation between the GBP and the EUR will materially drop, possibly as far as to zero. Such a movement would be consistent with a material rise in pound volatility.

We performed the same analysis for EUR/USD and GBP/EUR over the same time periods and have summarised the 3-month points (end of July) in Table 2, shown below. In the event of a Brexit, we should expect the pound to lose against both the US dollar and the euro. We should also expect the euro to lose against the US dollar, and we should expect the pound to lose more against the dollar than the euro loses against the dollar. We believe that the correlation between the GBP and the EUR will materially drop, possibly as far as to zero. Such a movement would be consistent with a material rise in pound volatility.

Stress Testing

While the FX markets provide valuable information about both the likelihood of a Brexit and the expected GBP, EUR and USD responses, we believe a wide range of asset classes should be stressed as part of a robust portfolio risk assessment. This analysis is meant to provide a framework for stresses financial portfolios whether or not they are directly invested in UK and European securities, as the contagion from a Brexit will be widespread throughout the financial markets.

In the first months following a Brexit vote, worldwide equities are clearly likely to fall. Following the ordinality of the currencies, UK equities will likely suffer more than Euro equities which will likely suffer more than other worldwide equities. A flight to quality away from the Eurozone will pull UK and Euro fixed income securities somewhat lower while money flows to safe havens like US bonds and gold, thus increasing those prices. Commodities can be expected to take a hit as worldwide sentiment is depressed.

Taking these ranges of movements, we applied a correlated / predictive stress test using all of these factors for three portfolios: a typical Global Long/Short Equity Fund, a US Institutional Investor Portfolio, and a European Asset Management Portfolio. We ran two stress tests: a “small” Brexit, taking the minimum values for each factor in Table 3 (e.g., GBP down 5% and US Bonds up 2%) and a “large” Brexit, taking the higher end of the range for each factor. We performed a multi-variate regression analysis on the constituents of the three portfolios to estimate the potential impact on such a portfolio. The results are shown in Table 4 below.

Finally, and possibly most importantly, we expect market volatility leading up to June 23 to follow a simple rule: the closer the FX options’ markets are to a 50% likelihood of a Brexit, the higher will be the volatility. If the implied probability is in the range of 30% to 70%, we believe that markets will be volatile and will have priced themselves at a correspondingly appropriate level. The danger is that if, in the weeks and days preceding the vote, markets imply a low likelihood of a Brexit, say 10% or 15%, with correspondingly low volatility and elevated prices, traditional risk measures may materially underestimate the potential losses. Only predictive stress tests, like the ones shown above – using multiple global factors – would capture the potential losses from a surprising vote for the Brexit. Whichever way the people of Great Britain vote on June 23, their decision will impact markets around the world.

By Damian Handzy, Global Head of Risk and Seddik Chacrone, North American Head of Risk at StatPro.

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