FX Strategy: Hedging EUR/GBP exposure in a Brexit risk scenario

Transcription

1 FX Strategy: Hedging EUR/GBP exposure in a Brexit risk scenario Morten Helt Senior Analyst mohel@danskebank.dk, March 2016 Investment Research Important disclosures and certifications are contained from page 10 of this report

2 Hedging EUR/GBP exposure in a Brexit risk scenario The UK s EU in/out referendum set to be held on 23 June represents a big event risk for GBP. The main risk for sterling is associated with the UK s large current account deficit and its negative net international investment position (NIIP). A significant Brexit risk premium has already been priced into the FX market: implied volatility and option skews are at extreme levels while a risk premium of around 3.5pp has been priced into the EUR/GBP spot rate according to our calculations. EUR/GBP has declined substantially over the past couple of weeks in reaction to less negative risk sentiment on global financial markets and not least to expectations of additional ECB easing. We see a risk that the ECB might disappoint the market s expectations on 10 March, which would lead to a higher EUR/GBP (see ECB Preview: Another 'menu' of easing, but will it be enough?, 7 March 2016 for more details on our ECB view). Moreover, we think that more Brexit risk premium is likely to be priced in as the referendum moves closer. In all, we see risks skewed on the upside for EUR/GBP in the coming months going into the referendum, and we think the recent decline in EUR/GBP has created a window of opportunity to establish GBP hedges. Recommendation: In our view, EUR-based clients should maintain a high short-term FX hedge ratio on GBP risks. Given the large digital risk, we generally recommend hedging GBP exposure via options. Based on our Brexit risk premium estimate in the magnitude of 2-5pp relative to spot, we suggest that EUR based corporates should hedge GBP income via a boosted risk reversal. 2

3 UK s current account deficit is main risk factor for sterling The main risk for sterling is associated with the UK s large current account deficit and its negative net international investment position (NIIP). As a deficit country, the UK relies on foreign investment and funding to finance its current account deficit. If it is no longer able to refinance its loans, or if investors no longer want to invest in the UK, it may have to run a current account surplus, forcing domestic residents to spend less and/or requiring a depreciation of the GBP. In addition, the UK s external balance sheet is exceptionally large by international standards which all else being equal increases GBP risk. In a Brexit scenario, the short-term risk would be a possible withdrawal of short-term funding and hot money outflow (portfolio investments) from the UK, while a decline in foreign direct investments would tend to maintain depreciation pressure on the GBP over the medium-term horizon. UK s significant current account deficit... Source: Macrobond Financial, Danske Bank Markets... and negative NIIP are risk factors for GBP Source: Macrobond Financial, Danske Bank Markets 3

4 A significant Brexit risk premium is priced into the FX market Since mid-november, we have seen a significant divergence between EUR/GBP spot value and the fair value implied by our short-term financial models. Given the decline in UK interest rates relative to EUR rates and the negative risk sentiment, which our short-term financial model takes into account, the model still fails to explain the entire move higher in EUR/GBP. Assuming that the deviation developed since mid- November can be attributed to Brexit risk premium, we estimate that a risk premium in the magnitude of 2-5pp relative to spot (median estimate 3.5pp) is currently priced in. Indeed, part of the steep decline in UK money market rates, which currently imply an approximately 40% probability of a BoE rate cut in 12 months time, could be due to Brexit uncertainty and increased risks to the growth outlook. Hence, we would also expect UK interest rates to increase if the British public vote to stay in the EU, supporting the case for a larger decline in EUR/GBP than implied by the estimated clean risk premium in this scenario. Significant divergence between model and spot value observed since mid-november Source: Macrobond Financial, Danske Bank Markets Estimated Brexit risk premium based on Danske Bank s short-term models Source: Macrobond Financial, Danske Bank Markets 4

5 Outlook for EUR/GBP in a no Brexit scenario Short term: higher ahead of referendum due to uncertainty Given the high uncertainty surrounding the EU referendum, we see risks skewed to the upside for EUR/GBP ahead of 23 June. A substantial Brexit risk premium has already been priced into the FX option market, and further significant GBP selling pressure is not likely to be seen before we come closer to the referendum. However, volatility is likely to remain high and EUR/GBP is likely to be very sensitive to newsflow, changes in polls and so on. Lower 6-12M in a no Brexit scenario Longer term, the outlook for EUR/GBP very much depends on the outcome of the EU referendum. In our main scenario, we assume a status quo for the UK, meaning that people vote to remain in the EU. This implies that GBP should appreciate immediately after the referendum. Longer term, we project further EUR/GBP downside driven by relative growth and relative monetary policy. We target EUR/GBP at 0.74 in 6M (0.71) and 0.73 in 12M (0.75) but stress that these forecast are subject to significant digital risk. Relative rates alone cannot explain GBP depreciation Main scenario forecast: 0.78 (1M), 0.80 (3M), 0.74 (6M) and 0.73 (12M) EUR/GBP 0.65 Feb-15 May-15 Sep-15 Dec-15 Mar-16 Jul-16 Oct-16 Jan-17 75% conf. int. 50% conf.int. Forward Danske fcst Consensus fcst k EUR/GBP 1M 3M 6M 12M Forecast (pct'ile) 0.78 (52%) 0.80 (70%) 0.74 (26%) 0.73 (27%) Fwd. / Consensus 0.78 / / / / % confidence int / / / / % confidence int / / / / 0.88 Source (both charts): Macrobond Financial, Danske Bank Markets 5

6 EUR/GBP in a Brexit scenario The EU referendum represents a significant event risk for GBP. The FX option market s pricing implies that large fluctuations in either direction are highly likely. The UK s current account deficit is a significant risk factor for sterling. Risk is clearly skewed toward a weaker GBP. Besides the risk of volatility after the election, we would also emphasise that uncertainty about the medium-term outlook for GBP has increased significantly as well. Medium-term drivers for EUR/GBP: Flows: Flows are most likely EUR/GBP positive as GBP so far has been supported by FDI and portfolio investment flows. Growth outlook: Uncertainty about growth outlook will increase further in a Brexit scenario, with downside risk to investments and private consumption. Monetary policy: A more accommodative monetary policy may be needed to underpin the economy in a Brexit scenario. Weaker growth and monetary easing is to some extent priced in already M market implied risk % CI 70% CI 50% CI Forward Spot Source: Danske Bank Markets Medium term outlook also very uncertain EUR/GBP Expected initial reaction If Brexit Source: Danske Bank Markets? +18.8% -13.4% Medium term drivers: Growth Monetary policy Flows Valuation Time 6

7 Fundamental valuation models suggest that EUR/GBP at 0.90 should not be ruled out Danske Bank G10 MEVA-model Looking at fundamental valuations, both our medium term models (MEVA) and our PPPestimate ( long term fair value ) implies that EUR/GBP currently trades very close to what is assumed to be fair value. Given that exchange rates can deviate substantially from model-based equilibrium levels for prolonged periods of time and only converge slowly towards theoretical fair values, current fundamental valuations do not imply any barrier for further significant increase in EUR/GBP. Source: Eviews, Macrobond Financial, Danske Bank Markets Danske Bank G10 PPP-model The confidence bands derived from both our medium-term model and the PPP estimate imply that EUR/GBP as high as 0.90 for a period of time would be stretched but within the norm. Source: Bloomberg, Macrobond Financial, Danske Bank Markets 7

8 Hedging GBP exposure with volatility and skew at extremes Given the extreme uncertainty about the post referendum outlook for GBP and not least the digital risk of large fluctuations in GBP crosses (regardless of the referendum outcome), we strongly advise our clients with GBP exposure to obtain a high hedge ratio going into the referendum. Given the digital risk we generally recommend hedging GBP exposure via options. GBP income : Buying GBP put options is a safe but quite expensive way to hedge GBP income. As an alternative to buying vanilla GBP put options, clients should consider minimising cost by hedging with volatility neutral/selling option structures. Given our estimate of a Brexit risk premium in the magnitude of 2-5pp, we suggest a boosted risk reversal (see next page for details). GBP expenses Utilise the extreme option skews to hedge GBP expenses via risk reversals. GBP volatility has increased more than other majors May 2010 election Scottish referendum May 2015 election GBP volatility is calculated as the average of 3M EUR/GBP and GBP/USD at-the-money volatility; other G10 currency volatility is calculated as the average of 3M EUR/USD, AUD/USD, USD/CAD, USD/JPY and NZD/USD volatility Source: Bloomberg, Danske Bank Markets GBP puts have become expensive Based on 1Y 25 delta risk reversals Source: Bloomberg, Macrobond Financial, Danske Bank Markets 8

9 Hedge GBP income via boosted risk reversal In a remain scenario, our Brexit risk premium calculations suggest that EUR/GBP most likely will drop to the range of (median ). See page 4 for details. Given this likely post referendum outcome in a remain scenario, we think that a boosted risk reversal strategy is currently the best way to hedge GBP income. A 6M hedge strategy can be entered at zero cost (indicatively, spot ref.: ) by buying EUR/GBP call option with a strike at and selling EUR/GBP put option strike with a double notional. The strategy offers full protection on the upside above , which is the same effective exchange rate obtained by buying 6M at-the-money call option with a strike at (cost indicatively 310 GBP pips). Note, that due to the double amount of the sold put option, this strategy is a not secure hedge given the theoretical unlimited loss potential in the event of an extreme decline in EUR/GBP. If the negative P/L from the boosted risk reversal is converted into the effective exchange rate, the boosted risk reversal strategy is better that the FX forward as long as spot trades above at maturity in a remain scenario. In the event of Brexit the FX forward offers the most attractive effective exchange rate (assuming that EUR/GBP increases in this scenario). Distribution of EUR/GBP level in a post remain vote scenario Probability of outcome Put option strike in suggested boosted risk reversal strategy: Source: Danske Bank Markets 6M boosted risk reversal Break even versus FX forward: Source: Danske Bank Markets +/- 2 standard deviations implied by Brexit risk premium calculations EUR/GBP post election level in a remain scenario implied by Brexit risk calculation (+/- 2 std.dev range). Current spot:

10 Disclosures This research report has been prepared by Danske Bank Markets, a division of Danske Bank A/S ( Danske Bank ). The author of this research report is Morten Helt, Senior Analyst. Analyst certification Each research analyst responsible for the content of this research report certifies that the views expressed in the research report accurately reflect the research analyst s personal view about the financial instruments and issuers covered by the research report. Each responsible research analyst further certifies that no part of the compensation of the research analyst was, is or will be, directly or indirectly, related to the specific recommendations expressed in the research report. Regulation Danske Bank is authorised and subject to regulation by the Danish Financial Supervisory Authority and is subject to the rules and regulation of the relevant regulators in all other jurisdictions where it conducts business. Danske Bank is subject to limited regulation by the Financial Conduct Authority and the Prudential Regulation Authority (UK). Details on the extent of the regulation by the Financial Conduct Authority and the Prudential Regulation Authority are available from Danske Bank on request. The research reports of Danske Bank are prepared in accordance with the Danish Society of Financial Analysts rules of ethics and the recommendations of the Danish Securities Dealers Association. Conflicts of interest Danske Bank has established procedures to prevent conflicts of interest and to ensure the provision of high-quality research based on research objectivity and independence. These procedures are documented in Danske Bank s research policies. Employees within Danske Bank s Research Departments have been instructed that any request that might impair the objectivity and independence of research shall be referred to Research Management and the Compliance Department. Danske Bank s Research Departments are organised independently from and do not report to other business areas within Danske Bank. Research analysts are remunerated in part based on the overall profitability of Danske Bank, which includes investment banking revenues, but do not receive bonuses or other remuneration linked to specific corporate finance or debt capital transactions. Financial models and/or methodology used in this research report Calculations and presentations in this research report are based on standard econometric tools and methodology as well as publicly available statistics for each individual security, issuer and/or country. Documentation can be obtained from the authors on request. Risk warning Major risks connected with recommendations or opinions in this research report, including as sensitivity analysis of relevant assumptions, are stated throughout the text. Date of first publication See the front page of this research report for the date of first publication. 10

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