Implied Distributions From GBPUSD Risk-Reversals And Implication For Brexit Scenarios
Efficient Frontier Consulting Ltd
June 13, 2016
Much of the debate around a potential British exit (Brexit) from the EU has centered on the potential macroeconomic impact. In this paper, we instead focus on understanding market expectations for price action around the Brexit referendum date. Extracting implied distributions from the GBPUSD option volatility surface, we estimate that the market expects a vote to leave could result in a move in GBPUSD from 1.4390 (spot reference on 10 June 2016) down to a range in 1.10 to 1.30, i.e. a 10-25% decline – very probably with highly volatile price action. In contrast, a vote to stay could result in a modest bounce in GBPUSD to around 1.47. We apply the same analysis to contrast the behavior of the GBPUSD option market in the run-up to the Brexit vote with that during the 2014 Scottish Independence referendum, finding the potential impact of Brexit to be considerably higher.
Implied Distributions From GBPUSD Risk-Reversals And Implication For Brexit Scenarios – Introduction
In the United Kingdom 2015 general election, the Conservatives campaigned on the basis of holding a public referendum on whether the United Kingdom should remain a part of the European Union. The election was held on 7 May 2015 and the Conservatives were elected into government. Since then, and up to the date of writing this paper, much attention has been focused on the possible scenarios attached to the “Brexit” question. Much of the analysis has been on potential macroeconomic impact from the UK exiting the EU. For example, the UK Treasury recently published a report  which discussed the economic impact on the UK of leaving. They suggested that:
the effect of this profound shock would be to push the UK into recession and lead to a sharp rise in unemployment.
In contrast this paper discusses market expectations of how assets will trade following Brexit. We focus on extracting the market expectations for price action following a Brexit vote using the foreign exchange options market. Many market commentators  have predicted that in the event of a “leave” vote, that sterling will depreciate potentially dramatically (a sterling devaluation of 20% is predicted by at least one currency manager in the event of Brexit), though this view is by no means universally held. A recent poll of currency forecasters by Reuters  suggested that GBPUSD would fall 9% in the event of a leave vote, whilst it would rise 4% in the event of a remain vote. We seek to understand whether these analyst forecasts are also reflected in the GBPUSD volatility market.
On 22 February 2016, the Conservative Prime Minister David Cameron made a speech to the House of Commons, in which a referendum date of 23 June 2016 was set. The announcement of the timing of the referendum date makes it possible to apply more quantitative methods to the analysis of how sterling may perform after the Brexit referendum date.
Options markets are a forward looking measure of the market’s expectation of how trade-able assets perform. Breeden and Litzenberger  point out that a complete knowledge of the prices of traded options at all strikes suffices to infer the risk-neutral probability distribution, on that expiry date, for the asset. This fact has been seized upon by Malz  in the context of foreign exchange to infer future exchange rates from the market today.
Whilst obviously the outcome of the Brexit referendum vote is unknown beforehand, we do know the referendum date. When there is an event risk whose timing is known, such as an election or an economic data event, options markets will price in the expected volatility of that event.
For events which are common, such as the US employment report, pricing is somewhat easier. The US employment report is typically released on the first Friday of each month. In Figure 1, we plot EURUSD implied overnight volatility together with the event volatility add-ons for US employment report days, using a simple model which compares overnight volatility just before the nonfarms payroll [NFP] data release with more typical days. On average, we note that the overnight implied volatility is typically around 4% higher on US employment days in this sample using our model. In contrast, unlike for the US employment report, the Brexit referendum vote has relatively few precedents. Perhaps the closest event to the Brexit referendum vote is that of Scottish independence, which we discuss later in this paper. However, it is not simply the level of implied volatility which is impacted by events, but also of course the skew in the volatility surface.
This paper therefore seeks to analyze information available in the short-dated volatility skew in GBPUSD options to assess the market expectation for GBPUSD as we cross over the expiry threshold, corresponding to FX spot on 24 June 2016, when the result should be known. While it is true that the EURGBP rate is more directly sensitive to a possible UK exit from the EU, GBPUSD is a more commonly traded currency pair and has a more liquid options market. We could also argue that EUR could be impacted more by a Brexit vote than USD. Hence, evaluating the event risk via GBPUSD would provide a cleaner representative method to evaluate the risk to GBP of Brexit.
We have obtained historical spot and implied volatility quotes from Bloomberg, together with poll data from the Economist. For the poll data, Figure 2 shows how the “remain” vote has generally held a very slight lead amongst respondents over the “leave” vote during 2016; however when the “leave” poll exceeds “remain” then this is usually followed by a sharp decline in GBPUSD spot. This does suggest that an actual “leave” vote on 23 June would be significantly negative for GBPUSD.
In Figure 3 we see time series for 25-delta and 10-delta risk reversals from 1 May 2015 to the date of writing of this paper, together with GBPUSD spot (on the right hand axis). There are several salient features to observe. Firstly, we see the risk reversals converging towards zero in late 2015 during the relatively innocuous period up to 5 November, at which date they start to move into increasingly negative territory over a week or two. This period coincides with David Cameron’s Chatham House speech, in which he outlined four key demands for renegotiation, as a prelude to an eventual British referendum.
The risk reversals continue to become more negative over the rest of 2015 and the early part of 2016, up until 20 February, when the Brexit referendum date (23 June 2016) was announced. At this point, all options with time to expiry in excess of four months were all exposed to Brexit risk, and we see the 6M and 1Y risk reversals move further. 25-delta risk reversals of 3M tenor and shorter move in a separate cluster between -0.5 and -1.5, until 23 February, when the 3M 25-delta risk reversal rolls in to have 23 June as the expiry, and therefore experiences a large negative spike as the Brexit uncertainty becomes reflected