In the early days following the referendum announcement on February 20th many assumed that the remain vote would win out but the opinion polls now indicate a much greater chance of a Brexit than was previously the case. This means that there is now much greater uncertainty in the market and heightened reactions in the currency markets to each set of opinion polls. The fact that the markets are much more uncertain about the outcome of the vote is being reflected in greater foreign exchange market volatility especially for the pound. This makes it much more expensive for companies to hedge the risk of a large movement in the pound against currencies such as the dollar and the euro. For instance, according to the markets, the current $1.42/£1 exchange rate of the pound has a 95% chance of ending up in the region of $1.55/£1 to $1.29/£1 over the next week which is a potential 9% movement. Over the next two weeks, which now covers the referendum result, there is a 95% chance of ending up in the region of anywhere between $1.94/£1 to $0.90/£1 a dramatic approximately 36% movement one way or the other ! These potential extremes are unprecedented in recent times and reflect the high degree of uncertainty about the outcome forthcoming referendum result.
Many large firms have not surprisingly been assessing the risk to their businesses from such large potential movements in order to manage their currency exposure and businesses. A large depreciation of the pound can eventually boost exports and reduce imports but significant order changes for exports and imports can take 12 to 18 months to occur. In the meantime a depreciation of the pound raises the cost of imports pushing up the inflation rate. Exchange rate volatility on the other hand is only likely to adversely affect international trade volumes if it persists for a significant period of time as companies can manage such risk over the short term by using futures and options contracts. Futures contracts guarantee a company a certain exchange rate in say three months or six months time. While options contracts give the company the right to buy or sell at a currency at a particular exchange rate in the future. Most large multinational companies will have already expected much higher volatility than normal in the run up to the referendum and taken out contracts to manage their risk exposure for the next six months to 12 months and will not be too greatly affected in the short term whatever the result. Some, however, will not have done so and will find their profit and loss accounts will be heavily affected by a large currency movement.
Figure 1 Sterling Implied Volatility last 5 Years using monthly data
The increased uncertainty in the last two months about the result means the cost of buying protection against a large depreciation (or appreciation) of the pound has increased dramatically as is show in the monthly candlestick chart Figure 1 which shows that potential volatility on the pound has risen dramatically in recent months to the highest level in over 7 years to 28.33 at mondays close. A red candle indicates expected volatility is down for the month with the wick indicating the highest and lowest volatility forecast for the month. While a grey candle indicates volatility is up for the month with the wicks again indicating the highest and lowest points for the month. It is now much more expensive for companies to protect themselves against large currency movements than in early May when the index was reading just 10 see Figure 2:
Figure 2 Sterling Implied Volatility last 3 months using daily data
In the end the result will be known, and either sterling will strongly appreciate on a remain vote to perhaps to $1.55/£1 or depreciate to perhaps $1.25/£1 on a Brexit vote. Thereafter, one would expect a high degree of volatility following a Brexit vote for a prolonged period of several months but much lower volatility on a remain vote. Some currency speculators will make large profits and others will make large losses once the result is revealed. Eventually, there will be a period of tranquillity until another major event hits the currency markets. My personal belief as expressed in an article last week LINK1 is that a Brexit will be a disaster for the UK economy and its citizens for a long period of time, irrespective of the currency effect.
Note A modified version of this post is published in Theconversation.com of 14th June LINK2