Sep 17, 2014

Part I: The Implications of the Scotland Referendum – An Expert View with Udi Sela

While the world holds it breath waiting for the results of the Scotland Referendum due September 18th, Numerix FX expert Udi Sela, provides his perspective on the pending results and the impact it could have on the foreign exchange markets—not to mention the broader impact it could have on the financial sector overall. Mr. Sela also contemplates an interesting options strategy to consider given this major political event.

Sela UdiQ:  

If Scotland does in fact break away from the United Kingdom, how might this impact the financial sector within the UK?

A:

There will be problems. You have lots of asset managers in Scotland and a number of banks and large insurance companies. At this point a number of these firms have already announced that they would move their headquarters to London as part of a contingency plan, this could present significant issues for Scotland.

Of course too, there will be difficulties in future trade between Scotland and the United Kingdom because of potential different currencies used by the two states. This creates friction and adds costs to doing business. Scotland has less than 6 million inhabitants – and not a big economy. Their main resources are oil and their financial industries. With a weakened economy, it’s an open question to see if the European Union would want to add Scotland to the Euro. Adding Scotland as an independent state could weaken the Euro further. In short, there’s is a lot of risk to consider.

Q:

If Scotland does break away, what kind of currency do you think they’ll be using in the future?

A:

This is an interesting point of discussion. From what I’ve read, The Scot’s wanted to keep using sterling but I don’t believe that’s going to happen. I feel The Scot’s will have their own currency, in the case of a Yes vote. They will have to apply to the European Union and decide if they want to be admitted. And then they’d have to decide if they’d like to join the Euro. The European Union will also have to determine if they want Scotland as part of the Euro mechanism.

Q:

Have there already been effects in the market even though the poll has not yet finalized?

A:

The Sterling has slumped down to the lowest it’s been since November 2013.  The Pound weakened from 1.7150, during July 2014 down to $1.6030 (since this low level, the spot rate stabilized at 1.62-1.63). Since the beginning of this month the FTSE has weakened by 1%-2%. 

Q:

If the final vote is a yes, what do you think the effect will be on the Sterling? Do you feel it will depreciate?

A:

I think most of it is already priced. I don’t think it’s necessarily bad for England and the rest of the Union, except Scotland. I feel the Scottish people stand to lose more than the British. So if Scotland wants to become a state, they would need to go to the international markets in order to issue bonds and finance their state, they would need a sustainable economy behind them.

Q:

Can you suggest an interesting options strategy given this major political event?

A:

Yes. Today, we are looking at a spread strategy:

•    Sell a Call GBP, Put USD option at 1.63 that expires on the 18th of September
•    Buy the same option would expire on the 25th of September (a week later)
•    Each option 10 million pounds
•    Our net payment is 17,000 pounds
•    Note – the time of the expiry is 3 pm London (10 am NY)

Rational:

•    If there’s a yes vote and the Sterling weakens below 1.6300, our loss is capped to 17,000 Pounds
•    If on the 18th 3 pm the results are unknown yet and the market remains below 1.6300, we stand to gain, with a later announced No vote, will call the Pound to rally (as the sold option has expired and the bought option is still “alive”)
•    If the Pound rally before the 18th of September 3 pm, our loss is capped to 17,000 Pounds  

As expected, current short term Implied Volatilities are extremely high, and this strategy capitalizes on this.

In our next blog, we will review the outcome of this strategy and the impact on the markets.

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