August 7, 2018 / 8:52 AM / 4 months ago

Breakingviews - Sterling’s Brexit jitters bigger than they look

A bank employee counts pound notes at Kasikornbank in Bangkok October 12, 2010. The Thai government agreed on Tuesday to impose a 15 percent withholding tax on interest and capital gains earned by foreign investors on Thai bonds, the latest bid by an emerging economy to tame its surging currency. From export-dependent Thailand to fast-growing China and Brazil, governments are moving to rein in their currencies as investors, turning their backs on low interest rates in the developed world, pour money into higher-yielding markets. REUTERS/Sukree Sukplang (THAILAND - Tags: POLITICS BUSINESS)

LONDON (Reuters Breakingviews) - Britain’s currency is jumpier than it might look. Options prices offer investors an easy way to check expectations of how much sterling is expected to move around. The relative calm implied by these measures masks a Brexit levy that only becomes apparent when they are compared with other major exchange rates.

Implied volatilities – a gauge of how much investors expect prices to gyrate – have been relatively subdued for a while in the foreign exchange market. True, one-year sterling/dollar volatility has risen a bit, to 8.9 percent from 7.8 percent a year ago. But it remains well below recent years’ peaks even though Bank of England Governor Mark Carney and Britain’s trade minister, Liam Fox, have in the past week highlighted the risk of a chaotic “no-deal” Brexit. The current levels are roughly a quarter below last year’s high and a third less than that for 2016.

So far so calm, on the surface. But compare sterling/dollar volatility with that of its peers, and a different picture emerges. Breakingviews constructed a basket of one-year implied volatilities for eight major exchange rates against the dollar, with each weighted according to its relative importance in overall trading volumes using Bank for International Settlements figures. In the decade to the end of 2014, one-year sterling/dollar volatility was on average 1.1 percentage points lower than that of the basket. But since Britain’s June 2016 EU referendum, the former is more apt to be higher than the latter.

This matters to investors and corporates who use FX options to protect themselves against currency risks, since they are probably paying more to purchase such insurance for sterling than would have been the case had Britons voted to stay in the European Union. The gap is also effectively a measure of Brexit-related risk premium associated with sterling and is clearly picking up.

Prime Minister Theresa May’s government has yet to agree the terms of separation even though there are less than eight months left until Britain leaves the EU. With her own trade minister putting the odds of exiting without a deal at 60-40, this true risk premium has plenty of scope to grow.

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