In terms of their international trade, it is apparent that the Eurozone and United Kingdom are very closely linked. In which if Britain exits, they will have to renegotiate many deals, some which may take up to years. An estimate from World Trade Organization analysts estimates almost 9 billion pounds in terms of import tariffs, an additional 5.5 billion pounds on British merchandise exports.
Data from the observatory of economic complexity shows that 58% of Britain's exports goes to Europe, while 63% of Britain's imports come from Europe. Post Brexit outcomes which reduce trade or increase the cost of trade would be detrimental to both Europe and Britain. The divergence between the pound and the euro would also be something to watch out. (NYSEARCA:FXE)
Assuming a yes vote and mass devaluation in the pound it would make exporters in Britain a lot more competitive which is something highlighted by Deutsche. While they are spot-on that many of FTSE 100 (MUTF:IIFPX) components rely heavily on export goods, this is of course in assumption to the elasticity of their goods as well as the maintenance of trade capabilities for these companies. Additionally, large cap stocks in the FTSE with more global exposure may be hit with more volatility and uncertainty.
Source: Liberium, Bloomberg.
Companies with very high non-UK revenue would bring in higher gross revenue after FX translation. However, from an external investor's point of view, the rally in the FTSE would most likely be a tradeoff from the depreciation in the pound (NYSEARCA:FXB), which would make this investment strategy a poor one. You would not want to convert your dollars into the pound for a higher equity return just to lose it to foreign exchange.
Source: Global Counsel
On the flip-side, the EU has a lot more to lose if Britain exits the EU. As pointed out in the uncertainty bullet, one of the biggest issues would be the political contagion that might plague Europe. A protracted negotiation of the process could take over more than 5 years. Political stability is seen as one of the more important measures spurring foreign direct investment, and the low confidence would affect new inflow of investors.
It is hard to say now the direct impact to all the rest of EU on the new relationship, supply chain and policy interests within the area. The single largest impact would probably be in increase cost of financing.
Source:Rytis Daukantas from Lithuania
One of the further down the line examples of uncertainty is that of contagion. During the Greece debt crisis, many pundits were speculating about how Greece would lead to Portugal, Spain and Cyprus possibly leaving the Eurozone and Brexit may cause this contagion.
If Britain leaves, the yield of gilts would most likely be pressured downwards. A global flight towards safety and a risk off perspective would leave investors rushing to safe assets.
Source: Thomson Reuters
A Brexit would likely delay any rate rise plan in prospects due to the more pressing issues of renegotiation of trade deals and stabilization of the economy.
During the Scotland referendum in 2015, there was a large run-up in gilts, with foreign investors buying record 29.6 billion pounds worth of gilts.
However, for longer dated gilts, there would exist a larger amount of uncertainty. The depreciation of the pound may force inflation upwards, necessitating raising rates and the yield of gilts. However, the same argument for equities can be found in terms of investors looking into gilts, as an international investor, the meltdown in the pound may be detrimental to your position held.
One of the ways to play Brexit would be a play on volatility. As one might know, Brexit is a binary event and the final end result is either a YES or a NO.
However, even market movers and shakers would have little inkling of what would be the true outcome of Brexit. Currently as of writing, a live poll by the economist is almost an even split, with a 1% difference in margin.
If we are unable to properly determine the outcome of the Brexit vote, it would be a fool's gamble to try to trade one side of the trade and long or short the pound/euro.
What would be a better option instead would be to trade the volatility. The idea is simple, if the market is priced in 50% for a YES vote and 50% for a NO vote, as long as the eventual outcome is a YES or a NO
Source: Data from Thomson Reuters
One of the easiest ways to execute a volatility trade would be to purchase a Volatility Index such as the (NYSEARCA:VXX). There are many other volatility instruments out there that could possibly suffice your needs such as the (EVZ) Eurocurrency Volatility Index or (VSTOXX) Europe volatility benchmark.
One thing to take note about such indexes is that they naturally have a downwards induced time decay built into them. As such, it is only advisable to hold such indexes for a short amount of time. If you are interested you can read more here.
SPX Option Chain
Source: Data from Yahoo Finance
Another method you might say is to take a long straddle option, with both a buy call and a buy put. This is a volatility trade because as long as either side, as long as the movement is larger on the upside or the downside to cover the costs, a profit would be made. The following option chain shows the end June 30th chain. As observed, if you were to purchase at the money straddle 2700 (NYSEARCA:SPY), it would cost you roughly 65 give or take trading fees. A quick Calculation would tell us that the SPX would need to move roughly 2.4% either upside or downside for us to make a profit before expiration, a rather large margin.
BUT WAIT! You're going to ask me; Jun Wei isn't this whole debacle about Britain? Why are we talking about SPX here? Yes, even though it has more than 70% correlation (from my prior study) with (NASDAQ:DAX) and Eurostoxx (NYSEARCA:FEU), we probably can have a cleaner execution of a Brexit play directly via the pound.
A call compared to the at the money put for the pound dollar is markedly cheaper, around 130 pips difference give or take. The combined cost for an at the money straddle would be around 670 pips in total. The costs for such options have been pricing in the expectations of Brexit over time.
Of course there were a large amount of other factors in play such as Scotland and struggles in Eurozone such as the Greece crisis. However with only 3 days till the referendum, we can be sure that the market already been pricing in for the event.
All in all, trying to play Brexit is a very difficult game. It is inherently difficult to squeeze out any Brexit plays from equities and bonds due to the inherent FX play. As for FX, nakedly shorting the pound is a terrible decision either and you could be hit very hard in terms of a No vote. Instead, it would be smarter to do a play on volatility and understand the costs involved before you do so.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.