UK: Sterling Storms and Fat Tails – Deutsche Bank
Research Team at Deutsche Bank, suggests that with the UK’s referendum on EU membership approaching on the 23rd June, short-end GBP vol has risen dramatically.
Key Quotes
“Three month GBP/USD implied vol has now reached the highest levels since 2010. We remain bearish on the pound, but think that the move in vol has gone too far.
First, it has not paid well historically to own sterling vol. Over the last decade, the market has imbedded a much larger risk premia for GBP/USD than other G10 FX, meaning that vol has failed to justify option prices more than 70% of the time. In more recent memory, investors have been burnt by buying vol at already elevated levels ahead of recent political events like the Scottish referendum and UK general election.
Second, the pricing of the referendum date itself now looks very expensive. Overnight vol for 23rd June is 90%, implying a daily range of over 4.5% at current spot levels. Based on a distribution of GBP/USD returns since 1990, this would be a more than 6 standard deviation event. Put another way, on only five occasions in the last twenty-six years has the daily move in GBP/USD been larger; three of those around Lehman, one preceding and one after the UK’s exit from the ERM. A UK exit from the EU would be a significant policy challenge, but it is not Lehman. Moreover, as option prices for that day must also factor in the prospect of no “Brexit”, the actual range implied by markets under an ‘out’ vote is larger still.
Third, even assuming a “Brexit” vote, how far could sterling collapse on the day? One problem is that if polls are sufficiently close as they are currently, any move lower in the pound may already be partly priced. The Bank of England has also been much more active than for the Scottish referendum in signaling its willingness to stabilize financial markets by offering liquidity operations around the date of the referendum itself.
Fourth, while we have argued that “Brexit” would be an unambiguous sterling negative, the extent of the impact depends on the outcome of renegotiations that would take years, not months, to conclude. Unlike with the Scottish independence referendum (or a Greek exit from the Euro Area), an exit would not immediately jeopardize the functioning of the UK’s banking system nor involve a fiscal breakup.
In sum, we believe the current levels of vol to be too expensive. However, they may provide an attractive cheapening for other ways to express a medium term bearish sterling view based on fundamentals (like yesterday’s very weak current account numbers). This is particularly true given the inverted vol curve. For example, a 9m 1.37 GBP/USD put with a WRKO expiring in 4m time with barrier 1.27 offers a 60% cheapening to the vanilla (indicative pricing).”
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