Prime Minister David Cameron has promised a referendum by the end of 2017 and while a date is yet to be finalised, talk has intensified in the past few weeks that it could happen in June this year
Some fleet-footed currency investors are stepping up bets against the British pound in the derivatives market on expectations that a vote on Britain's membership of the European Union will be held this summer.
Prime Minister David Cameron has promised a referendum by the end of 2017 and while a date is yet to be finalised, talk has intensified in the past few weeks that it could happen in June this year. With the outcome unclear and opinion polls showing voters almost evenly split, investors are bracing for volatility and further weakness in the pound.
Options market pricing shows a jump in the cost of hedging against volatility between six and nine months from now - a period many expect to cover the vote. Six-month implied volatility traded around 9.3 percent, while the 9-month rate was at 9.9 percent.
The two-month option was at just 8.25 percent, making the two-six month volatility gap unusually wide.
"We are seeing some fast-money flows into options that are expiring between six and nine months," said a trader with a North American bank. "The timing of the referendum is still in the air, but options expiring between July and September are getting attention."
Sterling hit a 5 1/2-year low of $1.4326 and a one-year low against the euro on Friday, making it one of the worst performing major currencies in 2016. Traders said the weakness partly reflects concern about a possible exit by Britain from the EU -- also dubbed "Brexit" -- and which analysts say would hit UK growth and investments.
PIMCO, amongst the world's largest bond investors, said on Thursday that a vote to leave would likely cut economic output by 1 to 1.5 percent in the following 12 months and raise doubts over the ability of the Bank of England to raise interest rates.
Also, in the derivatives market, six- and nine-month risk reversals -- a gauge of demand for options on a currency rising or falling -- show a bias for sterling weakness picking up in that period.
Reuters data shows that while the three-month risk reversal is at -1 vol, the six-month is almost double at -1.95 vol while the 9-month is at -2.25 vols. To put it in context, while the three-month euro/dollar risk reversal is being bid at -0.7 vol, the 6-month is at around -1 vols and 9-month is at -1.2 vols.
In the stock markets too, implied volatility on the benchmark FTSE 100 equity index had risen, though Ankit Gheedia, a equity derivative strategist at BNP Paribas, said concerns over Brexit were being played out more on the currency market rather than the stock market.
The timing of a referendum depends to a large extent on the outcome of a Feb. 18-19 European Council summit and what the country can wrangle out. Britain would need at least four months to prepare for a vote once a deal is struck.
Cameron is trying to reform Britain's membership terms before a vote but faces an uphill battle securing a deal on curbing welfare to migrants, as EU rules forbid discrimination on grounds of nationality among EU citizens.
"We think Cameron will need to secure a deal and announce a referendum date by at least mid-March," said Viraj Patel, currency strategist at ING.
"While there are sound reasons to stay positioned for sterling weakness, we may see the landscape change materially in the aftermath of the February EU leaders summit as the terms of the deal will shed light on the likelihood of a "Brexit".