Friday, June 24, 2016

Investors Do Not Believe The British Economy Will Suffer Due To Brexit

It looks like the investors do not believe that the Brexit is going to have a significant impact on the British economy. 

For example, today, in the morning, the 10 year gilt yields (gilts are bonds issued by the British government) dropped 25% in heavy trading:

However, in my opinion, investors took advantage of this event and used much lower exchange rates between the British Pound and other currencies to buy gilts. 

Let me present a short analysis of this event, taking the American investor as an example. 

The 10 year gilt bears a coupon of 2%:

source: Bloomberg

Let us assume that the investor is buying the 10 year gilt at 7.38 a.m. paying 108.08 pounds. Here are cash flows embedded into this deal:

An internal rate of return for the above case is 1.14%. It means that an investor buying a 10 year gilt today and holding it until redemption will earn 1.14% a year.

Yesterday a 10 year US bond was yielding 1.69%. Assuming that an American investor wants to earn at least 1.69% on buying gilts for US dollars (why would this investor want to earn less?) let me check what exchange rate between the British pound and the US dollar would have to be to fulfill this scenario.

The cash flow is below:

Note, that today in the morning the exchange rate GBP / USD was 1.36981:1 so an American investor paid US$148.05 for a gilt worth GBP108.08.

To earn 1.69%, the exchange rate has to be standing at 1.44, which means that American investors think that in the coming years the British Pound should go up 5.1% against the US dollar (1.44 : 1.36981), on average.

I have no idea whether an American investor is right about it but he / she surely expects that the British Pound should go up. 

On the other hand, if that is the case, investors are trying to take advantage of the fact that the British Pound slumped to lowest levels since 1985: 

Well, I am curious what George Soros thinks about it.

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