Cost Of Hedging Sterling Exposure Soars As UK Election Nears

Apr 10 2015 | 7:00am ET

By Anirban Nag (Reuters) - Rising nervousness in the currency market about the risk of prolonged political uncertainty after British elections next month has driven the cost of protection against wild swings in the pound to multi-year highs.

Unlike last year, when many were caught napping by sharp moves in sterling shortly before a referendum on Scottish independence, hedge funds are taking no chances this time, traders said.

Funds and investors have been buying options to protect themselves against sterling volatility and placing bets against the pound in recent months, a trend that is likely to continue.

Opinion polls show the ruling Conservatives and the main opposition Labor Party neck-and-neck before the May 7 vote, with Scottish Nationalists who want to break up Britain likely to be the third biggest group in the Westminster parliament.

That makes likely a hung parliament, in which no party wins overall control, and investors fear coalition negotiations will drag on much longer than after the last election in 2010.

These concerns are weighing on sterling, which fell to $1.4729 on Thursday - not far from a five-year low of $1.4635 struck late in March. It was also weaker against the euro .

Currency options, which investors use to "hedge" their exposure to a currency or to speculate on it rising or falling, suggest markets see an elevated chance of more volatility in the pound after the election.

One-month implied volatility in sterling/dollar, which measures how sharp swings will be in the currency pair, rose on Thursday to 13.60 percent, its highest since September 2011, Reuters charts showed. The options contract, which expires on May 11, started trading at 11.60 percent on Thursday.

"There is a lot of uncertainty. Polls and projections are continuing to suggest that a hung parliament is the most likely outcome, and that neither of the major parties will be able to form a coalition with less that two other partners," said Hamish Pepper, currency strategist at Barclays.

"To that extent, we think there is a prospect of a prolonged process of negotiation following the election day itself."

In 2010 the Conservatives and Liberal Democrats formed a coalition in five days but this time negotiations are likely to last longer as smaller parties are expected to win far more seats - including the Scottish National Party, which still seeks independence despite losing the referendum.

The election could also lead to a referendum on whether Britain should remain in the European Union, which the Conservatives have promised within two years if they win.

Risk reversals, a gauge of demand for options on a currency rising or falling, show a huge bias for sterling weakness against the dollar in the coming month.

"We continue to believe that the uncertainty around the outcome of the UK election and the post-election policy environment is likely to keep deterring not only domestic investment but also foreign direct investment flows, which would leave sterling vulnerable," Morgan Stanley said in a note.

Data on Thursday showed Britain's trade deficit at a seven-month high in February, boding ill for an already-high current account gap.

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