This guest article was written by Charles-Henri Sabet, CEO of London Capital Group.
The Brexit has been a leading driver in the financial markets over the last six months and has clearly injected a sizeable amount of volatility both in the currency, equity and bond markets. Given the risks and the implications surrounding such a historical event, all types of investors, from retail to institutional, find themselves profoundly involved with Britain’s EU membership issue. Hence, Britain’s decision to ‘Remain’ or to ‘Leave’ is no longer considered as a national matter but an important global event.
Put options have never been as popular, while the spread between put and call premiums stretched to all-time highs.
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From investors’ perspective, hedging against Brexit risks has been the most crucial theme since the beginning of 2016. Investment portfolios needed a solid hedge against risks of depreciation in the pound and against the danger of a damaging sell-off in UK and European stocks. Volumes in the option markets reached important levels. Put options have never been as popular, while the spread between put and call premiums have stretched to all-time highs. Increased activity in alternative markets have impacted the pound’s volatility measures, the FTSE and the Gilt markets. As of today, we can at least say that the market is comfortably hedged against the risk of Britain walking away from a twenty-three year partnership with the European Union.
Nevertheless, hedging against Brexit risks did not prevent the market from considering the ‘Remain’ vote as the base case scenario. The significant hedging activity certainly impacted spot markets in the run up to the referendum. In this respect, the pound lost 13.5 percent between June 2015 to March 2016 and the monthly volatility on pound-dollar spot market reached a seven year high. FTSE 100 stocks wrote off more than 20 percent of their value in ten months. This being said, long-term investors and macro managers continued to base their decisions on the EU’s intact unity. As a result, we shall say that the market is well prepared for a potential Brexit event. Yet paradoxically, the pricing across the financial markets did not evolve in line, or according to the close call we could observe via a number of recent opinion polls.
There lies the risk for short-term investors and retail traders. While the ‘Remain’ vote should trigger a relief rally in an environment of reasonable volatility, a ‘Leave’ vote, which is still a tangible option, could generate an important sell-off across the global asset markets. As petrifying as it sounds, the downside potential is perhaps larger and is insufficiently factored in.