ERIK NORLAND, SENIOR ECONOMIST AND EXECUTIVE DIRECTOR
CME GROUP
11 MAY 2016
Brexit: A Rational Look
at Irrationalities
All examples in this report are hypothetical interpretations of situations and are used for explanation
purposes only. The views in this report reflect solely those of the author and not necessarily those
of CME Group or its affiliated institutions. This report and the information herein should not be
considered investment advice or the results of actual market experience.
As we mentioned in a previous article on options prices
and the ‘Brexit’ vote, traders of British pounds (GBP)
are much more concerned about the possibility that the
United Kingdom (U.K.) might leave the European Union
(EU) than are euro (EUR) traders. Normally, GBP implied
volatility is lower than that for the euro. This relationship
has reversed sharply in recent weeks ahead of the June 23
vote (Figure 1).
Options prices out of the money reveal a wealth of
additional information regarding what investors believe
and fear about the referendum. In a nutshell, the
probability distribution that one derives from GBP and
EUR options of various strike prices shows that insurance
on GBP is exceptionally expensive on the downside, and
that almost nobody is pricing a risk that GBP could rally
against USD (Figures 2 & 3).
Figure 1: GBPUSD Options Significantly Exceed
EURUSD Option Implied Volatility At The Money.
Figure 2: GBP Options Price a 10.8% Chance of a 10%
Fall And a 3.6% Chance of a 10% Rise by July 31.
Probability Distribution for GBPUSD
Implied from July 2016 Options Volatilities
Implied Volatility on 90 Day Options in %
0%
2011
2012
2013
EURUSD
Source: Quikstrike (6E_90 and 6B_90)
2014
2015
2016
1.78
1.73
1.755
1.68
1.705
1.63
1.655
1.58
1.605
1.53
1.555
1.48
1.505
1.43
1.455
1.38
1.405
0
1.33
2%
1.355
4%
0.005
1.28
6%
0.01
1.305
8%
1.23
10%
0.015
1.255
12%
1.18
14%
0.02
1.155
EURUSD (U.S. Dollars Per Euro)
18%
16%
0.025
1.205
Likelihood That Expiry Occurs within the
Range Between Two Strike Prices
20%
Strike Price of Option
GBPUSD
GBPUSD
Source: Quikstrike (GBP Implied Probability)
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11 MAY 2016
Figure 4: U.K. Unemployment is Half
The Eurozone Rate.
Figure 3: EUR Options Price a 3% Chance of a 10%
Fall And a 2.3% Chance of a 10% Rise by July 31.
Unemployment Rates
0.045
14
0.04
12
0.035
0.03
10
0.025
8
0.02
0.015
6
0.01
4
0.005
0
1.3
15
16
20
14
13
20
20
20
12
11
Eurozone
Source: Quikstrike, EUR Implied Probability
20
10
20
09
20
20
07
08
20
20
05
06
20
04
20
20
02
03
20
20
00
20
EURUSD
01
0
Strike Price of Option
20
1.28
1.25
1.265
1.22
1.235
1.19
1.205
1.16
1.175
1.13
1.145
1.1
1.115
1.07
1.085
1.04
1.055
1.01
1.025
0.98
0.995
0.95
0.965
2
0.93
Likelihood That Expiry Occurs within the
Range Between Two Strike Prices
Probability Distribution for EURUSD
Implied from July 2016 Options Volatilities
U.K.
Source: Bloomberg Professional (UKUEILOR and UMRTEMU)
GBP options imply a 10.8% probability of a 10% decline
from the current level (1.44 against USD at the time of this
writing) to 1.295, and only a 3.6% probability of a 10% rise
to 1.585. This essentially reflects three-to-one odds that a
10% fall is more likely than a 10% rise.
EUR options, by contrast, are much more evenly balanced.
As of Friday, May 6, they price a 3% chance of a 10% fall
and a 2.3% chance of a 10% rise in EURUSD.
Figure 5: U.K. Core Inflation is 1.5x That of
The Eurozone.
Core Inflation Rates
4.0
3.5
3.0
2.5
2.0
1.5
1.0
What’s more is that the fear of a ‘Brexit’ appears to have
blinded markets to certain economic realities. ‘Brexit’ or
not, the U.K. economy is much healthier than that of the
eurozone. It has much lower unemployment (Figure 4)
and the U.K.’s core rate of inflation is half a percent higher
than the eurozone’s (Figure 5). This implies to us that the
Bank of England (BoE) is probably much closer to a rate
increase than is the European Central Bank (ECB), which
is still contemplating further policy easing and will extend
quantitative easing well into 2017.
0.5
0
Eurozone
15
16
20
14
20
20
12
13
20
11
20
10
20
20
08
09
20
20
07
20
05
06
20
20
03
02
01
04
20
20
20
20
00
-0.5
20
While the pound would most likely react negatively to a
vote to leave the EU, we are not convinced that EUR and
GBP options should be priced so differently. As we have
pointed out in our article Brexit: More Pain for EU than
Britain?, the risks of a ‘Brexit’ are not exclusive to Britain.
The vote also holds a great deal of significance to the
nations of the eurozone as well. A British exit from the EU
could send a signal to other countries, notably Greece,
that they too can think about leaving, opening the door to
possible debt defaults and other turmoil.
U.K.
Source: Bloomberg Professional (UKUEILOR and UMRTEMU)
The fact that so few people apparently expect (or fear)
that GBPUSD could rally might actually increase the
odds of a big rally in ‘cable,’ a trade slang referring to
the GDPUSD exchange rate. Moreover, the economic
differences between the U.K. and the eurozone also favor
a higher GBP versus EUR.
This doesn’t rule out a selloff in the pound should the
U.K. vote to leave –a possibility to which participants at
Ladbrokes, Paddy Power and Predictit.org assign roughly
a 25%-30% probability. Indeed, opinion polls are showing
that the “leave” vote is gaining the upper hand.
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11 MAY 2016
Nevertheless, market sentiment towards the pound is
so negative at the moment that one should consider the
possibility of a big rally in the currency should the “stay”
vote prevail, and only a modest downside should the
“leave” vote rule the day. Viewed from a USD perspective,
the pound and the euro often move in tandem (Figure 6)
but the ‘Brexit’ vote will surely put the usual correlation
pattern to a severe test.
One factor that has supported EUR versus both GBP and
USD is the unexpected reaction of markets to negative
deposit rates. After the ECB set the deposit rate at -0.4%,
EUR rallied. This may be because negative deposit rates
serve as a tax on the banking system and may be contracting
monetary policy. If the ECB lowers lending rates into
negative territory – a possibility in the near future—that may
have the opposite effect and expand the supply of euros,
lowering their price in both USD and GBP terms.
Figure 6: Brexit Weighed on The Pound in Late 2015
and Early 2016. Is The Risk Fully Priced?
FX Spot Rates: EURUSD and GBPUSD
1.8
1.6
1.7
1.4
1.6
1.3
1.5
1.2
1.1
1.4
1
1.3
0.9
GBPUSD (U.S. Dollars Per Pound)
EURUSD (U.S. Dollars Per Euro)
1.5
1.2
0.8
2011
2012
2013
EURUSD
2014
2015
2016
GBPUSD
Source: Bloomberg (EUR and GBP)
3