Please rotate your device to landscape mode to view the charts.

Detecting Political Event Risk In The Option Market

Journal: Journal of Banking & Finance

Date: 2022

Author: Alexandros Kostakis, Liangyi Mu, Yoichi Otsubo

Abstract:
This study shows that the option market can ex ante detect and quantify the effects of political event risk. Focussing on the 2016 UK referendum on EU membership, we find that the Risk-Neutral Distribution extracted from GBPUSD futures options whose expiry spans the referendum date becomes bimodal and the Implied Volatility curve exhibits an unusual W-shape. To the contrary, the corresponding effects for FTSE100 are found to be very limited. The large swings in expectations regarding the event outcome during the referendum night allow us to observe the counterfactual and validate the ex ante information revealed in the option market.

Link: Google Scholar

Background and Context

The Event

The 2016 UK referendum on EU membership presented a unique opportunity to study how financial markets price political event risk before the outcome is known.

Data Sources

The study analyzes options data from GBPUSD futures traded at Chicago Mercantile Exchange and FTSE100 Index options traded at Intercontinental Exchange.

Methodology

Researchers extracted Risk-Neutral Distributions from option prices using a non-parametric approach to detect and quantify political event risk.

GBPUSD Risk-Neutral Distribution Shows Clear Brexit Impact

  • The distribution becomes bimodal before the referendum, showing two distinct possible outcomes
  • Left mode at $1.31-1.35 indicates expected value under Leave outcome
  • Right mode at $1.50-1.53 indicates expected value under Remain outcome

Sharp Decline in GBPUSD During Referendum Night

  • GBPUSD dropped from $1.50 to $1.32 as results came in showing Leave victory
  • 17 cent decline validates the option market's pre-referendum pricing
  • Shows markets accurately priced the magnitude of potential Brexit impact

Volatility Spikes Under Leave Scenario

  • Remain outcome associated with 10-15% volatility
  • Leave outcome associated with 25-35% volatility
  • Shows markets expected significantly higher uncertainty under Leave scenario

Option Market vs Betting Market Predictions

  • Option market showed higher probability of Leave victory than betting markets
  • Option-implied probability reached 50% a week before referendum
  • Betting markets never exceeded 41% probability for Leave outcome

Limited Impact on FTSE100 Shows Market Discrimination

  • FTSE100 dropped only 3.2% instead of predicted 8.7%
  • Index recovered and rose 2.6% by end of June
  • Shows markets distinguished Brexit impact across different assets

Contribution and Implications

  • Demonstrates that option markets can detect and quantify political event risk before the outcome is known
  • Shows option markets can distinguish different impacts across assets, helping investors manage political risk
  • Provides a framework for measuring potential impact of future political events using option market data

Data Sources

  • RND visualization based on data presented in Figure 3
  • GBPUSD price movement based on data from Figure 11
  • Volatility comparison based on data from Figure 13
  • Probability comparison based on data from Figure 12
  • FTSE100 impact based on data discussed in Section 3.2