On September 18 the people who live in Scotland will get to vote on whether to leave the UK. It's been the general view that they would probably vote NO and stay in the UK, but some recent opinion polls have suggested that the vote is much more evenly balanced, and the price of GBPUSD has fallen from around 1.66 to 1.61 (it's recovered to about 1.62 as I write - the latest poll showing a 6 point lead for a NO vote).
Without going into too much detail on this there are major implications for a Yes vote, here's two:
1. Some 90% of the UK's oil revenue would be reassigned to Scotland. This would leave a huge gap in the UK's trade balance.
2. Much of the UK's (very significant) financial services industry is domiciled in Scotland. It's likely that they would move to London, but there is uncertainty, and the Markets don't like uncertainty.
When the referendum result is announced on the 19th the GBPUSD price will move significantly. I have read that in these situations where the price of a security is expected to move a large amount in a short space of time that the Black Scoles model mis-prices the options.
I intend to monitor the situation on the 18th with a view to buying a GBPUSD strangle/straddle, and closing it the following day, after the result has been announced.
Any advice on this - will the big players already have factored any likely move into their pricing? How far OTM strikes should I be looking at?
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GBP: Trading The Scottish referendum – Credit Agricole
While likely to be highly volatile, GBP should hold above last week’s lows ahead of, and then rise following, the confirmation of a ‘no’ outcome from Thursday’s Scottish referendum.
Clearly however the result is tight, and a surprise ‘yes’ outcome could produce a significant (ie, >3%) decline in the GBP NEER. Beyond the dominance of this event, we remind readers to stay focused on underlying GBP-positive fundamentals.
Thus while secondary, labour and inflation data next week will also be important. Improving business activity bodes well for hiring intentions, labour market conditions and thus wage price developments.
Given the MPC’s focus on such wages developments, speculation surrounding future policy moves will remain a GBP driver.
This combined with further improving growth prospects should make the GBP subject to upside risk in the week ahead.
A Bit of History. If Scotland leaves the U.K., the event would not be without precedent. After an overwhelming victory by Sinn Féin in the 1918 general elections, Ireland declared its independence from the U.K. in 1919. Although Irish independence led to a three-year guerilla war, it is instructive to examine the economic fallout for Ireland in search of potential parallels for Scotland today.
After Irish independence, there was much economic hardship. The new government extended selective protectionism to full-scale protectionism. Old age pensions were reduced. The Irish punt was pegged to sterling (and remained so until in 1979), and the predominantly agriculturally-based Irish economy suffer years of deep recession. For history buffs, Barry (2014) provides an excellent tract on the Irish economic sovereignty.
Scottish Economic Independence. The Scottish economy is clearly better positioned for independence than Ireland was in 1919, and we see few parallels except for the currency issue. Scotland has a thriving manufacturing economy and more diversified sources of economic growth than its southern neighbor. A proposed cut in the VAT tax would further stimulate growth. Consider also the natural resources of Scotland: the new country would control territory waters which provide European with 90% of its fish consumption as well as the North Sea oil platforms. The major concern for the Scottish economy would be financial dislocations, notably the uncertainty over the question of monetary independence. Whether or not the new government adopts sterling as the currency of an independent Scotland in monetary union with the rest of the UK is still unsure. The creation of a new Scottish currency would lead to uncertainty on the scale of potential currency fluctuations and would require new cross-border payments systems to be set up. Risk premiums on interest rates would increase with negative implications for bank's asset and liability management. In addition, the Bank of England would no longer act as lender of last resort. Would a new Scottish central bank have the resources / credibility to back-stop banks? A separate Scottish financial regulator would be likely to add to compliance costs and complexity for Scottish financial institutions with large cross-border businesses.
Broadly Scotland's GDP is around one-tenth of that of the rest of the UK and the main economic effects of independence would therefore be felt in Scotland. A recently report to Parliament highlights many transitional issues and costs (in addition to the financial concerns just cited):
An early, transitional problem would be assuming Scotland's share, perhaps £93bn, of the UK's public sector debt.
The UK's single market brings economic benefits to Scotland and the rest of the UK. If fragmented after Scottish independence, Scotland's smaller economy would be disproportionately affected.
North Sea oil decommissioning costs will be very substantial.
The Scottish Government would need to make timely arrangements to levy its own taxes on independence. Even if an independent Scotland's oil revenues broadly made up for the loss of tax revenue, they would be a less predictable source of revenue than transfers from the British Treasury.
An independent Scotland's share of the UK's public sector debt and its share of the UK's known future liabilities, based on relative size of population, would be around 123% of GDP.
Dismantling the current fiscal union would result in a loss of risk-sharing mechanisms between an independent Scotland and the rest of the UK.
It is not clear how Scotland would make the transition from its current inclusion in an EU member state to EU membership as a state in its own right, since there is no precedent in EU history.
A "Yes" vote in the referendum on Scottish independence would raise many complex issues of defense policy for the rest of the UK.
Trading Scottish Independence. Although Scotland only accounts for 2% of FTSE 350 sales, independence would send a negative ripple through world markets and present several companies with significant challenges. We recommend opening pair trades ahead of next Thursday's vote. On the short side, gas company BG Group, Royal Bank of Scotland, Lloyds Banking Group, drinks giant Diageo and defense company BAE Systems are among those companies that may experience a negative stock market reaction. We believe, based on the above financial/monetary fall-out from a "Yes" vote, that shorting banks with significant activities in Scotland would be the best way to play the independence vote.
On the long side of the pair trade, with the Scottish government's pledge to halve the Air Passenger Duty, traders could buy EasyJet, Ryanair and IAG. For macro traders, selling the FTSE 350 and buying the EuroStoxx would also offer a profitable pair trade.
We have added these companies to our trading models for investors to better track.
Conclusion. We feel that Scotland belongs in the U.K., both from a historical/cultural perspective as well as for a stronger UK economy. Nevertheless, the disruptions caused by a "Yes" vote would offer opportunities for astute traders to earn outsized profits from the likely sharp reactions in markets following a still too-close-to call referendum vote next Thursday.