There is no doubt that the vote by citizens of Great Britain to leave the European Union was an economic shock with few parallels. “Currency futures cash” (below) shows the relatively quiet system of six currencies disrupted on June 23 and 24, 2016, with a significant decline in the British pound.
If the Bank of England, the central bank of the United Kingdom, had devalued the pound sterling up to 10%, it would have incurred the wrath of the world’s central bankers. When the nation’s voters decided to leave the EU, the result was an immediate cost-free reduction in the pound’s dollar value of 11.84% over the June 24 to 27 weekend. The sudden drop resulted in sympathy instead of wrath, and perhaps a small cheer from the folks at Threadneedle Street.
The devaluation should be an advantage for Britain’s export business — one that may need to be offset by strategies of competing currencies to lower their prices relative to the pound. Meanwhile, the recent reduction in the pound could be the third and final leg in a three-part decline during the past three years in the continuing saga of currency warfare.
Four other currencies — the Swiss franc, Australian dollar, Canadian dollar and euro — joined the pound by dropping from 1.96% to 4.89% over June 24 to June 27, while the yen gained 4.02%. The other currencies quickly recovered from the Brexit shock and continued on a course approximating either zero cumulative percentage changes in price or slight increases. The Japanese yen did not experience the Brexit decline and increased along a volatile upward path.
In terms of currency warfare — which is like an economic golf game where the low score wins — the Brexit vote gave the pound a surprising win. How temporary or permanent the currency devaluation advantage will be depends on competition by currencies that are up a cumulative percentage from 2% to 10% from June 2 through Sept. 30, while the pound remained at approximately -10%. The differences may play in Britain’s favor during the necessary renewal of trade agreements over the next year or more.
Each of the six currencies has an associated exchange-traded fund (ETF). These include the CurrencyShares British Pound Sterling ETF (FXB), Swiss Franc ETF (FXF), Canadian Dollar ETF (FXC), Euro FTF (FXE), Japanese Yen ETF (FXY) and Australian Dollar ETF (FXA).
Forex ETFs are close matches for the percentage price changes registered by the currency futures. “Currency ETFs” (below) shows very small differences between the two series of cumulative percentage price changes between June 1 and Sept. 30, 2016. This means that analysis of potential spread trades may be based on ETFs as well as on futures contracts.
At approximately noon on Aug. 23, 2016, the prices, 52-week price ranges, and year-to-date percentage changes for the six currency ETFs were the following:
Puts and calls are another source of potential trading advantages given by the Brexit vote. December 2016 call options for the currencies are shown on “Calls on six currencies” (below). Relative volatilities — measured by the heights of the option price curve as a percentage of the strike price where the futures price equals the strike price — are the yen (2.81%), pound (2.61%), Australian dollar (2.54%), Canadian dollar (2.20%), euro (1.93%) and the Swiss franc (1.92%).
Because curves of the same height indicate closely matched option price equations, these are also good prospects for options pairs trading. On “Six currencies” two pairs are indicated by similar heights: the euro and Swiss franc, and the pound and Australian dollar.
“Dollar variations from predicted prices,” (below) shows the variations of calls from computed regression curves, going from small variations when the strike price is large compared with the futures price to the point at which the futures price is approximately equal to the strike price. The area of gold color indicates out-of-the-money calls where options are priced primarily by the exchanges or market-makers, resulting in theoretically accurate prices but with very small trading volume.
Options in the green zone are closer to being in-the-money with larger trading volume but also reflect market prices that are less controlled and farther from theoretically accurate. The negative variations for close to in-the-money options (the orange color) are caused by the regression curve — a log-log parabolic curve — rising above call prices that are trending toward their intrinsic values (futures prices less strike prices).
Although there are variations around the predicted regression price curves ranging from approximately $25 for pound calls to less than $6 for calls on yen futures, these are relatively tightly priced options. If $25 or $6 variations seem large, recall that the dollar value per option point is $62,500 for the pound calls, $100,000 per option point for calls on the Australian dollar and $125,000 per point for calls on the other four currencies. The currency calls do not permit many occasions for spreads between strike prices or trades based on mispricing. The yen, with the largest volatility in price (both actual and implied) is in possession of the best record for accurate pricing.
Because of its large percentage in the composition of the dollar index, the euro plays a major role in determining the value of other currencies relative to the dollar. The percentages of each currency in the dollar index are: Euro 57.6%, yen 13.6%, pound 11.9%, Canadian dollar 9.1%, Swedish krona 4.2%, Swiss franc 3.6%. A 1% decline in the euro should result in an almost 5% increase in the pound’s value in U.S. dollars. A shift of this size would give a trader an advantage in the use of the FXB ETF, pound futures or call options on the pound.
Other pairs are possible because of central bank efforts to narrow gaps between currency values. For example, the spreads between the yen and Australian dollar, euro and pound, and Australian dollar and pound will produce profits from pairs trading when the spaces between them begin to close up. “EFT difference: FXY – FXA,” (below) shows the spread between the yen and Australian dollar ETFs. During four months the yen’s volatility carries it up and back down several times to connect with the Aussie.
During the two-week period from Aug. 15 to Aug. 31, 2016, the six currencies experienced the following shifts in cumulative percentage price changes.
Although the prices will continue to vary in ways that are typical for each currency, the post-Brexit vote pattern may indicate a future path with the yen most variable at the top followed by — and competitive with — the Australian dollar. In the center, hovering near zero cumulative percentage price changes are the Canadian dollar, the euro and the Swiss franc. At the base is the pound sterling, holding at just above -10% and potentially gaining relative to the U.S. dollar due to declines in the euro and other currencies.
The trading advantage for the pound is having not just one competitive currency (the euro) potentially reducing its value in the economic competition with ever-lower interest rates, but all five competitors using similar tactics. The odds are 5-to-1 in favor of the pound’s value increasing in relative price.