“Sterling at lowest level since records began” – “another volatile day” – “unprecedented systemic shock”
Just a few examples of the powerful headlines blazoned across the media in the weeks and months that have followed the UK’s EU referendum result. But what can we really infer from the exchange rate movements and what does this mean for market risk? We dig down into the data behind the headlines.
This graph shows the distribution of daily GBP to USD exchange rate movements, since records began in 1975, using the following key:
We’ve taken a look at the exchange rate movements observed on key dates in 2016, where an increase in exchange rates corresponds to a decrease in the value of GBP compared to USD.
On 20th February, David Cameron announced the date of the UK’s EU referendum, but markets didn’t react markedly and the largest daily movements in the month were towards the beginning and the end.
On the 5th May, a number of UK elections and 27th May marked the start of a four-week purdah before the EU referendum vote. Whilst the value of GBP decreased, this was not significantly out of line with market volatility previously experienced around elections.
The 23rd June saw GBP rise as markets and forecasters predicted a Remain vote. But upon announcement of the Leave result, GBP crashed. The headlines are true – the 8.64% movement was the largest daily increase in the exchange rate since records began, almost double the longstanding record of 4.51% during November 1978. This illustrates the importance of making allowance in capital models for “events not in data”.
When Teresa May announced that Article 50 would be triggered in 2017, another increase was experienced – the markets do not expect the UK to get a good deal in EU exit negotiations.
Exchange rates are clearly volatile. But whilst these daily movements lie outside the distribution’s interquartile range, monthly movements have been somewhat more modest:
Only the exchange rate movement over the month of June lies outside the distribution’s interquartile range. What this graph does show is the continual weakening of GBP. Over the coming year, more weakening is forecast and what may have once been a 1 in 200 exchange rate increase is now considered to be more likely.
Market risk capital
From an insurer’s perspective, the primary consideration in relation to FX risk is asset and liability matching. We are already in an extremely low interest rate environment, so it is unlikely that the most successful insurers are relying on investment returns. Therefore the experience that really matters will be quarterly and annual movements.
Moody’s is just one of the ESG providers that responded quickly to the referendum result; revising its forward-looking assumptions and therefore the ESG output simulations. Insurers should continue to monitor economic forecasts against internal positions and ensure that capital can withstand extreme shocks.
We are already working with clients to understand the potential implications of Brexit on capital – the Brexit result and resulting market movements have provided insurers with more severe historical scenarios with which to back-test their models.