Hedging risk ahead of the referendum
Three months after the date was announced, the EU referendum is finally around the corner. Political campaigning and media coverage of the event is reaching a highpoint as both “Leave” and “Remain” camps make a final attempt to sway the voting public in their favour. Like the 2015 general election and Scottish referendum before that, the uncertainty linked to the outcome of the June 23rd vote is being played out on the global currency market. The Sterling has tumbled 8%* (on a trade weighted basis) in the past six months as an increasing number of economic reports have highlighted the potential downside risks to the UK economy from a “Brexit” scenario. For foreign investors, managing Sterling exposure from UK holdings will be an increasingly important consideration in the build up to the vote, as growing tensions and uncertainties continue to ripple through the currency market.
Referendum poses tail risks
When investing in foreign assets, investors, often unwittingly, acquire currency risk. An asset denominated in a currency other than that of the investor, always involves taking a currency position where exchange rate movements form a part of investment returns. Historically, this factor has often been overlooked, but in the current environment of record central bank activism and political uncertainty, it has never been more crucial. Globally, FX market volatility has risen to multi year highs and the trend appears unlikely to relent.
For non-Sterling investors with UK holdings, the referendum poses a currency risk. According to the latest analysis by the UK Treasury, the Sterling could be subject to as much as a 12%* drop should the vote result in a “Brexit”. While polls are showing a growing likelihood of a “Remain” outcome, option prices reveal that uneasy investors have purchased record levels of downside protection against the Sterling.
Figure 1: Currency induced volatility
(Click to enlarge) Source: Bloomberg, ETF Securities 80%85%90%95%100%105%110%115%120%Figure 1: Currency induced volatility
Need to hedge rises
The chart above compares EUR and GBP returns of a FTSE 100 position over the past 18 months. It highlights that a European investor with currency unhedged FTSE 100 exposure would have experienced daily returns that were 26% more volatile than that of an equivalent UK investor, all as a result of oscillations in the EUR/GBP exchange rate. As the referendum approaches, investors with UK holdings will need to assess their currency exposure and make a decision of whether to hedge this risk. In the current financial environment, currency movements are becoming more pronounced and events like the EU referendum have potential to prompt considerable volatility in investor portfolios.
This communication has been issued and approved for the purpose of section 21 of the Financial Services and Markets Act 2000 by ETF Securities (UK) Limited (“ETFS UK”) which is authorised and regulated by the United Kingdom Financial Conduct Authority (the “FCA”).