Brexit: A Risk Scenario Framework For Investors

With the British referendum to either remain or exit the EU quickly approaching, we would like to present a market stress scenario that can be used to estimate probable PnL impact on a buy-side portfolio to best predict what a UK vote in favor of Brexit on June 23rd really means.
 
The majority of economists predict a lower economic growth rate (or recession) in the UK economy in the medium to long term if Britain opts to leave the EU.  This would result in a degree of uncertainty in the EU and UK economies, as the UK makes up almost 15% of the EU's economy in nominal GDP terms.  The UK's current account deficit with EU partners makes the referendum even more important, as the UK would have to sell more debt to finance it.
 
If Brexit were to happen, sterling could exhibit major downward pressure, the Euro would weaken, credit spreads would widen, equity markets would be on the downhill worldwide with the greatest impact in the UK and EU.  On the flip side, US treasuries and gold would rally due to flight to quality -- but only until the impact is fully understood and realized.
 
Market implied probability of Brexit from FX option market (GBP/USD, EUR/USD) shown by BLOOMBERG (BRXVLEAV Index) in the past week (June 13th to June 20th) was in the range of 25%.  As a result, as we get closer to decision day, market implied probability could be lower or higher.  There is no guarantee that the outcome would be against Brexit even if the probability were to further drop from its current level.
 
Our goal is not to predict the event outcome but to create a scenario framework that would enable calculation of downside PnL impact.  Our stress scenario is driven by an instantaneous GBP/USD move of 10% (expected) and 20% (worst) post-Brexit event.  The below scenario is predictive/conditional, accounting for correlations across asset classes/indices/ benchmarks on current levels so if GBP/USD moves down by 10% EUR, USD would move down by 5% based on a 50% correlation between USD/GBP and USD/EUR pairs of the past year's returns.