Financial markets hinge on probabilities. Risk models at banks and hedging decisions at investment funds typically work with expected scenarios. The projected chance of an event may dictate whether a fund manager shorts $100 million of stocks in Asia or a bank boosts its holdings of U.S. Treasuries.
That's basic finance. When the probabilities are wrong, things can get ugly.
That's perhaps the biggest risk that a Leave vote in the U.K. poses now. Markets are assigning a less than 30 percent chance that Britain will vote to exit the European Union. They have rallied so much this week that the potential downside of Brexit in stocks, currencies and bonds has become much greater than the upside.
Investors and risk managers look to be basing their decisions on the odds reported by bookmakers. On Wednesday, the bookies saw a mere 25.4 percent chance that the British people will vote Leave, according to an index of betting flows compiled by Oddschecker. Currency options, which have moved broadly in tandem with the betting market, implied a 19.6 percent probability of Brexit.
Financial literature suggests people with money at stake -- such as bookmakers or investment funds -- tend to be much better at predicting outcomes, from corn crops to soccer matches. They don't always get it right, though. Given how divided the polls have been, good risk management would suggest assigning almost an equal probability to Leave and Remain, and hedging accordingly. That's clearly not been happening.
As a result, the sell-off that would follow a Leave vote is potentially much sharper than the relief rally that would be triggered by a win for Remain. Last week gave the world a taste of how skewed the market moves could be. A series of polls that showed the exit camp gaining ground sent markets into a tailspin as investors rushed to protect positions. The reversal of that trend brought everything back to where it was two weeks earlier. That may be just a sample of the volatility that will follow the actual vote.
An adage of finance is that risk can be quantified, but not uncertainty. Markets may have been relying too much on gamblers to assess what remains a most uncertain outcome. This is going to be a crazy night at the casino.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
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