How to Trade on U.K. Exit from EU Stress Before Market Tunes In

The Ramifications of a Possible ‘Brexit’
  • RBS advises using options market to protect against volatility
  • Aim of trade is to be `ahead of the curve,' says strategist

It’s not too soon for investors to take out insurance against the U.K. fleeing the European Union.

QuickTake Will Britain Leave the EU?

As Commerzbank AG to UBS Group AG advise clients to pay more attention to the so-called Brexit debate and warn sterling may eventually slide when talks heat up, Royal Bank of Scotland Group Plc is going one step further.

Even with Prime Minister David Cameron still to set a date for a vote on whether the U.K should stay in the bloc, RBS strategists are proposing ways investors can position themselves right now for the higher market volatility and uncertainty they expect when the referendum campaign is fully under way.

“We want to make sure we’re ahead of the curve on it,” said Andrew Roberts, head of European rates strategy at RBS in London. “We should be looking to see now if there are trades that can be entered into to take advantage of this not being too much on radar screens yet.”

Options Markets

With that in mind and as polls show growing support for the U.K. withdrawing, RBS colleague Clement Mary-Dauphin has devised cheap, slow-burning trades in the options market to hedge against the market fallout of a contentious battle over Brexit. He times them to expire between late 2016 and early 2017, the period RBS views as the likely timing for the plebiscite.

One approach would use swaps to bet on a “bear steepener” in which the 10-year swap rate rises more than that on 2-year gilts. The investor would impose conditions to protect against losses if rates stayed at current levels or fell, yet would lose money if the short-dated rates rose faster than their long-term equivalents.

At the heart of the trade is the assumption that foreign investors are less likely to hold sterling assets when the referendum is nearing. If exit looks likely, then U.K. gilts would suffer too.

“In that scenario we believe that the Bank of England will also struggle to tighten policy given the uncertainty around the implementation of Brexit,” said Mary-Dauphin in a report to clients last week. “This is the scenario we are trying to hedge against.”

For RBS, the lesson from recent votes such as the U.K. election in May and last year’s poll on Scottish independence is that markets often react too late to political events and that investors can benefit if they are more alert to the looming Brexit debate. Chancellor of the Exchequer George Osborne said it was time to be prepared to “up the temperature” in the negotiations.

“RBS is not expressing any opinion whether Brexit is likely or not, we are just saying that the referendum isn’t the center of attention yet,” said Mary-Dauphin. “That’s why we suggest early insurance trades.”

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