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Brexit and foreign exchange market expectations: Could it have been predicted?

  • S.I.: Networks and Risk Management
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Abstract

In order to gauge foreign exchange market expectations prior to and after the Brexit vote in June, 2016, this paper examines European options written on the GBP/USD and GBP/EUR exchange rates in 2016. First, the parameter estimates from a non-parametric option pricing model with a homogeneity hint show that the Brexit announcement was to a certain extent expected because the implicit probability density functions were negatively skewed in January–February, 2016 and April–June, 2016. This effect was more pronounced for the GBP/USD exchange rates, indicating an increased pessimism of the U.S. currency traders relative to their European counterparts. Entropic risk measures based on skewness premia of deepest out-of-the-money options confirm the findings from implicit distributions. Moreover, these new risk measures are found to statistically significantly predict foreign exchange market volatility at daily to monthly time horizons.

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Notes

  1. Brexit and its geopolitical consequences represent political (Hammer et al. 2011) and systemic (Zhu et al. 2018) types of risk.

  2. Options are financial derivatives whose value (i.e., price) depends on the value of the underlying security. For example, a European call (put) option based on an exchange rate provides its buyer with a right to purchase (sell) a predetermined amount of currency at a contracted price (“strike exchange rate”) on a specific future date (“maturity”). For this right, the buyer of an option pays a price called the premium.

  3. RSI is a technical indicator that measures the momentum behind price movements. An oversold condition (RSI<30) suggests the price has moved too low too quickly. A break back above 30 should indicate a correction (Bloomberg: Technical Analysis Handbook).

  4. Out-of-the-money options are those that are not profitable to exercise (e.g., for a buyer/holder of a put option, it is the situation when the spot exchange rate is greater than the strike exchange rate).

  5. The SPD is the second derivative of an option-pricing formula with respect to the strike price.

  6. In an additional exercise performed by the author, it is found that the coefficient of correlation between the daily smirk measure and the daily changes in entropic measures ranges from − 0.10 to − 0.15. The implied volatility smirk measure for exchange rate i on day t is calculated as the difference between the implied volatilities of out-of-the-money (OTM) puts and at-the-money (ATM) calls: \(SKEW_{i,t}=VOL^{OTMP}_{i,t}-VOL^{ATMC}_{i,t},~~t=1,\ldots ,T\) and \(i\in \{GBP/USD,GBP/EUR\}\). Therefore, the negative sign of the correlation coefficient is as expected because larger smirk measures correspond to the prevalence of pessimistic FX market’s aggregate expectations and lower entropy.

  7. The author is grateful to the Guest Editors and the anonymous Referees for this and other insightful comments and suggestions.

  8. This variable will be explained in data description.

  9. This choice is based on the forecast horizon of interest that is roughly two months. The main results of the paper are not sensitive to moving window sizes from 30 to 70 days. Moving windows that are shorter than 30 days do not provide sufficient information for successful predictive performance. Moving windows that are longer than 70 days do not leave a sufficient number of data points for any meaningful analysis.

  10. More information on Euronext currency derivatives can be found at: https://www.euronext.com/en/market-data/products/euronext-currency-derivatives.

  11. The results for the GBP/EUR exchange rate are similar to Figs. 2,  3 and  4, but they are not as striking. The additional figures can be available from the author by request.

  12. One such example of the misspecifications of the Black–Scholes model is its substantial inaccuracy related to the pricing of the deep out-of-the-money options (Gençay and Altay-Salih 2003; Gradojevic et al. 2009). For these options, it was found that the Black–Scholes prices overestimate market prices while feedforward NN models provide a superior pricing performance.

  13. The results for the GBP/EUR exchange rate are similar to those for the GBP/USD exchange rate, but the fluctuations in the implied skewness and kurtosis are more moderate. The additional estimates and figures can be available from the author by request.

  14. The number in parentheses is the bootstrap standard error. One leave-out bootstrap with replacement for a window size of \(K=\) 50 observations is applied.

  15. This lag was chosen as the optimal, based on the causality exercises from Table 2. The entropies for the GBP/EUR exchange rate were not considered in the regressions, mainly due to their weak predictive power, as demonstrated in Table 3.

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Authors and Affiliations

  1. Department of Economics and Finance, Lang School of Business and Economics, University of Guelph, 50 Stone Road East, Guelph, ON, N1G 2W1, Canada

    Nikola Gradojevic

  2. Faculty of Technical Sciences, University of Novi Sad, Novi Sad, Serbia

    Nikola Gradojevic

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Correspondence to Nikola Gradojevic.

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Gradojevic, N. Brexit and foreign exchange market expectations: Could it have been predicted?. Ann Oper Res 297, 167–189 (2021). https://doi.org/10.1007/s10479-020-03582-z

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