Pound Hedging Is Pricey Even Before Brexit Risks Are Factored In

(Bloomberg) -- At first glance, the high cost of hedging pound weakness into year-end may seem linked to Brexit risks, but a closer look at options suggests otherwise.

Nine-month sterling-dollar put contracts, which capture the Dec. 31 deadline for the U.K. and the European Union to agree on a trade deal, now cost around 260 basis points more than calls. That compares with the 2020 average of 150.

Still, the pair’s so-called forward implied overnight volatility rates suggest the elevated pricing of put options has more to do with coronavirus-fueled risk upheavals than fears that Britain and EU will fail to reach a deal. That means hedging costs could climb more if the risk of a no-trade-deal Brexit increases.

Bloomberg’s pound-dollar volatility calendar shows traders are not looking for significant price swings in the pair either at year-end or on June 30, the last day the Brexit transition period to be extended.

Risk reversals, a barometer of market positioning and sentiment, now trade at levels seen when investors had braced for the risk of a no-deal Brexit in 2018 and 2019. However, this year’s slide in sentiment came as traders priced in the economic damage from the coronavirus pandemic.

Confusion over the U.K. government’s plan for the country’s haul back to normalcy has also weighed on the pound this month, especially in the spot market. Sterling was 0.2% higher Tuesday at $1.2365, but still down almost 2% in May.

• NOTE: Vassilis Karamanis is an FX and rates strategist who writes for Bloomberg. The observations he makes are his own and are not intended as investment advice

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