Brexit and sterling: the big hedge?

03 Sep 2018

Jonathan Pryor

Corporate Treasury

The uncertainty over Brexit has manifested itself in the state of the national currency. Volatility has been steepening over the past few months and the market is beginning to awaken to the prospect of a messy exit.

Ever get the feeling you’ve been here before?

In some ways, the past couple of months have been a return of 2016 in the lead up to the UK referendum. But, as the realisation of that vote becomes ever more present, things have started to get more interesting – ergo complex. It has appeared to be leading on a path to a ‘no-deal’ Brexit. Which we would put the current probability of this happening at 20%.1 
 

Hedging your bets

This uncertainty over Brexit has manifested itself in the state of the national currency.  
 
Political discussions are translating into uncertainty, particularly for owner-managers and finance directors who need to look longer-term in order to manage their treasury needs. Those with international exposure will also be needing to hedge against any severe currency fluctuations. In short, those managing treasury face a conundrum. Do they leap into more comprehensive currency cover for the next 12 months or take a chance and leave their requirements to the spot market?  
 
Importers will be acutely aware of the consequences of a painful exit, as they have already manifested themselves in the already historic lows of sterling versus the US dollar.   
 
It’s a headache that will be tough to avoid in the coming months but we believe there are strategies that can be put in place.  
Brexit
"A ‘no-deal’ scenario has a current probability of 20%"

Jonathan Pryor, Corporate Treasury

What price volatility?

Some of the shock is being priced in. The options market, which can serve the barometer for how market participants are viewing the likelihood of volatile world and market events, has caught on to the tornado of comment surrounding the circumstances of the UK’s exit from the EU.  
 
GBPUSD ‘at the money’ volatility has been steepening over the past three months, particularly in medium-term dates with six-month volatility (syncing with a time we may or may not be moving towards Article 50) hitting close to 9% from below 8% at the end of May. When compared to risk events in the past such as the Brexit decision and the financial crisis, the move is modest, so it may be wise to treat it as a tremor before a potentially larger eruption in markets. Notable indicators in options markets also point to there being increased demand in the market to position for GBP weakness as opposed to GBP strength.
Risk reversal, looking at the shape of the vol curve over 9m
So looking at the pricing, the market is waking up to the event risk of a Mexit (messy exit). 
 

Going vanilla

So what can those in business with sizeable currency exposures do to sleep easier at night? 
 
Internal factors can be controlled, such as budget costs, currency forecasts and the general logistics of Brexit planning. 
 
Externally, though, we are working with clients to come up with solutions that can guide them through any event risk in a cost-effective way and allow plenty of flexibility for their foreign exchange requirements and for their business over the coming months.
 
It’s important to remember that much of the risk here for the pound is all front-loaded so we’re beginning to see a trend of clients bringing a percentage of their 2019 requirements into a vanilla option.

Defence!

Many of our corporate clients are now making use of three and six-month vanilla options to shelter them from the collateral damage of a breakdown in negotiations. In effect, these options act as a proxy insurance policy to a collapse in sterling. 
 
A vanilla option provides complete flexibility. It allows for the Brexit ground to settle and empowers holders to make more informed decisions once a clearer picture of our exit is established. 
 
For example, a GBPUSD vanilla option to sell £500k and buy USD at 1.2500 currently costs 0.75% of the notional (£3,750).  By owning this option a client is able to protect their business from a Brexit disaster scenario of no-deal or a Mexit. 
 
Of course, it means you have the complete flexibility to participate in GBP strength if the UK does manage to achieve a clean and acceptable exit.  
 
Many clients who expect to purchase a total of £10m worth of USD in 2019 are using options to the tune of 50% to expire between November and January. Then with a view to rolling these out to the rest of 2019 once the haze has cleared on what our exit could look like.  
 
Such a flexible approach requires the expertise and resource of banking partners who understand your business and objectives. This is and will be vital to navigating your business through choppy markets and political instability.
 
There is a feeling of déjà vu around Brexit and heightened market anxiety but while politicians may dither, at least you can take a proactive step to mitigate currency risk for your business.  
 
1 View of Investec London Economics Team, 26 September 2018.

Reasons why Brexit impacts currency and remains high on the boardroom’s agenda:

1. Mixed signals from the UK government

Disagreements over the UK’s Brexit proposal (known as the Brexit White paper) have come to the fore. 

2. Unrest within the ruling party

The government’s job of presenting a unified front to Brussels in Brexit negotiations has become an increasingly tough challenge against a background of unrest within the Conservative Party.

3. There’s the increasing possibility of a no-deal outcome

With little progress in talks with Brussels, further effort is being put towards ‘no-deal’ Brexit preparations. This has left sterling reeling. 

4. A deadline is approaching

Hopes of an agreement being reached in time for an 18 October EU Summit have evaporated. A special summit in November and a scheduled December summit are now the more likely points for crunch talks.

5. Any deal will have to go back to the UK Parliament

Some ratification of any Brexit deal proposed within EU Parliaments would follow while the UK Parliament would also hold a ‘meaningful vote’.  As things stand, the UK is set to Brexit on 29 March 2019, with or without a final Brexit package. With the clock ticking, UK-focused investors are getting nervous.