Implied Distributions from GBPUSD Risk-Reversals and Implication for Brexit Scenarios

Abstract

Much of the debate around a potential British exit (Brexit) from the EU has centered on the potential macroeconomic impact. In this paper, we instead focus on understanding market expectations for price action around the Brexit referendum date. Extracting implied distributions from the GBPUSD option volatility surface, we estimate that the market expects a vote to leave could result in a move in GBPUSD from 1.4390 (spot reference on 10 June 2016) down to a range in 1.10 to 1.30, i.e. a 10-25% decline - very probably with highly volatile price action. In contrast, a vote to stay could result in a modest bounce in GBPUSD to around 1.47. We apply the same analysis to contrast the behaviour of the GBPUSD option market in the run-up to the Brexit vote with that during the 2014 Scottish Independence referendum, finding the potential impact of Brexit to be considerably higher.

Keywords: Brexit, Foreign exchange, options, implied distributions, Breeden-Litzenberger

JEL Classification: F31