17 May 2016

Financial Times: Upcoming UK vote on EU lifts sterling insurance cost

The cost of insuring portfolios and businesses against a collapse in sterling after the Brexit vote is rising, as sellers of insurance back away from the market, according to currency traders and strategists.

A relatively stable pound in recent weeks has diverged from the market for sterling options contracts. Rising option volatility reflects market makers — bank dealing desks that normally sell insurance to companies and investors — being less willing to risk exposure to volatility in the pound ahead of the June 23 referendum on British membership of the European Union.

The cost of hedging against large swings in sterling over the next two months — known as two-month implied volatility — is up from 10.72 per cent three weeks ago, to 16.85 on Tuesday. It reached 18.35 per cent on Monday, its highest level since 2009.

Three-month implied volatility peaked this year at 16.26 per cent on April 7, before dropping to 12.74 per cent, but has climbed again, reaching 14.81 per cent on Tuesday — moderating somewhat from Monday’s 15.86 per cent.

Currency strategists said while fears of a British exit, or Brexit, may in part explain the high cost of insurance options, lack of liquidity was a more likely factor.

Paul Lambert, head of currency at Insight Investment, said the experience of big currency fluctuations such as last year’s dramatic moves in the Swiss franc, left banks unwilling to take on exposure to sterling options.

Options sellers would themselves hedge their risks by trading in the cash market, he said.

“However, if prices widen then they will not be able to do so efficiently and may be left with exposure to adverse price movements,” Mr Lambert said. “Their response is to push up the price of such options to deter buyers.”

In the run-up to the referendum, sterling moves have tended to track opinion polls and betting markets, as well as economic data. The pound rose 0.9 per cent on Tuesday in response to polls moving in the Remain camp’s direction, before retreating after publication of poor inflation numbers.

One currency trader said trading in sterling was less volatile than sterling options for two reasons: the dollar was weak, and traders could easily move in and out of positions. Also, would-be buyers of sterling options were discovering it was hard to find willing sellers.

Full article on Financial Times (subscriptiton required)

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