Implied Distributions from GBPUSD Risk-Reversals and Implication for Brexit Scenarios

Abstract

Much of the debate around a potential British exit (Brexit) from the European Union has centred 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 originally estimated, based on our visual observation of implied probability densities available up to 13 June 2016, that the market expected that a vote to leave could result in a move in the GBPUSD exchange rate 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. To quantify this more objectively, we construct a mixture model corresponding to two scenarios for the GBPUSD exchange rate after the referendum vote, one scenario for "remain" and one for "leave". Calibrating this model to four months of market data, from 24 February to 22 June 2016, we find that a "leave" vote was associated with a predicted devaluation of the British pound to approximately 1.37 USD per GBP, a 4.5% devaluation, and quite consistent with the observed post-referendum exchange rate move down from 1.4877 to 1.3622. We contrast the behaviour 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.

Detecting political event risk in the option market

“…-Figure 1 here-Panel A shows that the RNDs extracted from options on GBPUSD futures expiring on 8th July and 5th August, i.e., after the referendum, are dramatically different from the corresponding RND computed from options with expiry on 3rd June, i.e., before the referendum. 12 In particular, the RNDs with a post-referendum expiry exhibit a mode shift to the right, much larger dispersion, and fatter tails. Equally importantly, the latter RNDs become strongly negatively skewed, whereas the RND from options with expiry not spanning the referendum is relatively symmetric.…”

Exchange rates and political uncertainty: the Brexit case

“…Korus and Celebi 2018; Hanke et al . 2018; Auld and Linton 2019; Clark and Amen 2017). None of these papers considers second moments—so they are unrelated to political uncertainty—or builds a model to interpret the relation between politics and exchange rates ‘structurally’.…”