Is your portfolio's fate dependent on Scotland's? Why is it that when a place known for haggis, kilts and bagpipes indicates it might want to be independent, the markets pay attention?

The usually rather boring pound sterling jumped to life in recent days, becoming one of the world's most volatile currencies. The trigger was a poll that suggested that the pro-independence camp in Scotland might hold the upper hand in the September 18, 2014 vote. Until recently, that event risk had not been priced in. All else equal, greater volatility warrants a lower price for an instrument (a security or currency). Prudent risk management takes into account the riskiness of the instrument.

Before we discuss specifics for Scotland, I would like to remind everyone that we are literally asking to be surprised by event risks of this sort in general as markets have been rather sleepy- evidenced by low volatility. In our assessment, this lull is a direct result of quantitative easing and related efforts by central bankers around the world that make risky assets appear less risky. Except, of course, the world is a risky place. So when something does pop up, the markets are taken by "surprise." Just as the sterling fell sharply, the same could happen to the S&P 500 or any other investment. After all, keep in mind that the independence vote is not news; neither is the fact that the yes-vote has been gathering steam. In this complacent market environment risks are being suppressed until they can't be ignored any longer - then they break out with a vengeance. It's in this context that investors may want to stress test their portfolios in general- the lack of volatility in your portfolio may be deceiving.

Event risk means that once the event is over, reality ought to settle in. If the vote is NO, i.e. Scotland remains part of the UK, it might cause a relief rally in the sterling. However, if the vote is YES, the outcome isn't all that obvious. Notably, while everyone is now glued to watching each poll, is Scottish independence, in the short-run might mean more uncertainty as it could trigger, amongst others, a challenge to Prime Minister David Cameron's government; there's also a lot of uncertainty around what might happen to the North Sea oil assets. But let's not forget that Scotland comprises less than 10% of Britain's GDP. Let's also not forget that when a country splits up, there may be a flight of mobile capital to the stronger. While Scots rightfully show that that they do quite well based on numerous economic measures, the vulnerability remains with Scotland, as it has to play catch-up with institutions building: what happens if depositors move their deposits from Edinburgh to London? An asset-liability mismatch for the financial sector could be rather precarious as the Scottish financial system is about thirteen times Scotland's GDP. If there is no access to a lender of last resort, it could destabilize Scotland.

The European Union, in our assessment, will initially play tough, arguing that Scotland will have to apply (and fulfill all criteria) to become an EU member, but ultimately would like an independent Scotland to become a member. Conversely, Scotland may try to take hostage some oil assets. In short, it will be haggling over haggis - a solution to many issues will be negotiated. This would take time.

There's a silver lining in all of this:

• Greater volatility is good. It's not good for asset prices, but it's good for the price discovery process and, as such, the long-term health of one's portfolio. It's not healthy that risky assets appear almost risk free; as it encourages capital misallocation, thus inducing bubbles and subsequent crashes.
• Greater volatility is good for currency investors. You may argue you don't care about those currently speculators, but you should, as 30% to 50% of international equity returns are due to currency moves. If you hedge out currency risk you are missing opportunities. If you ignore currency risk, you are taken for a ride. Active management of currency risk is something prudent investors may want to consider - and the latest flare-up may be the canary in the coal-mine that it's about time investors take currency risk seriously.
• Opportunities are being created. The same poll that suggested Scots will vote for independence also suggested 44% of Scots believe Scotland would be worse off economically as an independent country (vs 35% thinking Scotland would be better off); similarly, 41% of Scots thought they would be personally worse off with Scotland as an independent country (21% thought they would be better off). To me this suggests a proud Scot may well indicate in a poll that they favor independence, but it doesn't mean they'll vote that way. In a world where asset prices are expensive, it's refreshing to see value opportunities in the markets. And if there's a 'YES' vote, the opportunity may get even better.

On Tuesday, September 16, 2014, please join me for a "fireside chat." We will make most of the hour available for you to ask questions. Please register to participate. We no longer record our webinars (the regulatory overhead is too much hassle), so join live to get answers to the questions you always wanted to ask.

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