Short-term cost of hedging sterling swings

The short-term cost of protection against swings in the British pound jumped to multi-year highs on Thursday, with investors bracing for fresh uncertainty as Britons headed to vote in the most unpredictable general election in decades. Opinion polls ahead of Thursday's ballot showed the ruling Conservatives and the main opposition Labour Party neck-and-neck, while support for Scottish nationalists has surged, making a 'hung parliament' in which no single party has a majority the most likely outcome.
An inconclusive outcome means it could be days or weeks before anyone knows who will be in power. UK markets have been resilient despite the uncertainty, focusing more on economic policy and international trends rather than the fallout from a political stalemate. Nevertheless, hedge funds and investors are willing to pay higher premiums to buy protection against a sharp move in the pound's exchange rate days just after the election.
The overnight sterling/dollar implied that the volatility option, which expires on Friday when the results are due, rose to 33.125 percent, its highest level since at least mid-2010, according to Reuters data. The jump suggests investors are pricing in a possible trading band of about 2 percentage points, or about three cents, in one day and are seeking to hedge themselves against such a huge swing by buying options.
One-week implied volatility traded at 18.75 percent, near its highest since the aftermath of Britain's 2010 parliamentary election. "It is not surprising that the overnight and near-term implied vols have risen," said Peter Kinsella, currency strategist at Commerzbank. "The near-end costs of seeking protection are still very high. But if a Conservative government comes to power, we could see them fall rapidly."
Traders in London's right-leaning City say a relief rally in sterling is likely if it emerges that the ruling Conservatives are in a position to form a coalition government. However, they are also concerned about a Conservative promise to hold a referendum on whether Britain should leave the European Union.
In general, most investors worry that a weak minority government will not be able to deal with Britain's fiscal and current account deficits. Reflecting some of those worries, sterling was down 0.4 percent against the dollar at $1.5191, and shed 0.4 percent against the euro trading at 74.705 pence per euro. "As we go through the night and the picture becomes clearer there's plenty of potential for volatility to pick up, especially since volumes will be thinner during the overnight session," said Angus Campbell, senior analyst at FxPro.