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EURGBP Volatility Ahead – how to incorporate uncertainty into your decision-making process

EURGBP Volatility Ahead – how to incorporate uncertainty into your decision-making process

Francesco Podestà Private Equity September 2019
Financial theory states that the spot price of any free-floating currency will adjust over time to incorporate all external factors that might influence its exchange rate.

Source: ECB

The FX spot rate is the traded average of commercial cash flows and speculative bets. Many of these “bets” are placed via the options market, where traders pay and receive premiums to benefit from variability in the spot rate over a certain time period. The higher the expected volatility, the higher option premiums will be. Correspondingly, it is possible to use the traded premiums to calculate the implied volatility for the spot rate. We can therefore use option prices for a given maturity to determine how much uncertainty the market associates with that period of time.

“It’s not just the exchange rate that matters, but the underlying volatility – what is the option market telling us about that in the months to come?”

With the looming Brexit deadline of 31 October, the 15-29 October and 15 November option maturities have been particularly volatile. Implied volatility almost doubled between mid-July and the end of August, then swiftly dropped in the first half of September to levels seen just before the summer, following the approval of the Benn bill to make a no-deal exit illegal, as illustrated in the chart below.

Source: Chatham, ICE

The key feature of the chart is the difference in implied volatility between mid-October and mid-November (blue and grey lines), now at its highest level since July. This suggests that the market is pricing in substantial fluctuations in spot rates in the weeks surrounding 31 October.  It will be interesting to monitor how this differential changes over the coming weeks.

These days our clients often enquire about how to hedge FX exposures for transactions that are due to close in the month ahead. Another key topic of interest is how to set budget rates for 2020. Both issues will be substantially impacted by the FX rates in the coming weeks. Through financial modelling and accepting that what we are looking at reference points and not exact forecasts, we can come to two conclusions:

1. Forward starting volatility for the period 15th October – 15th November is still high

We can calculate the forward starting implied volatility during the month straddling 31 October. As one would expect from the previous chart, this volatility has fallen significantly since Parliament asserted itself as the ultimate judge of an acceptable UK exit deal. However, the expected volatility is still above 10.6% (annualised): 2% above the 5-year historical average.

Source: Chatham, ICE

2. The range for ‘’2 sigma’’ movements in EURGBP is >12% in a month

Going back to the concept of uncertainty, high implied volatility tells us that market participants are expecting the range for EURGBP movements to be broader than usual. Based on last Friday’s volatility , the EURGBP spot rate is expected to trade within a range of +/-3% with 66% probability, and within a range of +/-6% with 95% probability over the period 15 October – 15 November. The latter range reflects a “2 sigma” event (i.e. one that is very unlikely in most circumstances). In the present climate, however, ruling out “unlikely” events feels brave to the point of recklessness. If we want to learn from past experience, one should bear these ranges (or wider still) in mind when making business critical risk management decisions.

Source: Chatham

For more information, please contact Francesco Podesta, Director at Chatham, at fpodesta@chathamfinancial.com.


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