UK election fog prompts surge of FTSE 100 puts

Negative bets on the FTSE 100 rose sharply last week, suggesting investors are belatedly seeking downside protection for their UK equity holdings in expectation of a period of political uncertainty following the UK general election tomorrow

UK election result may spark FTSE fall

Fears that the UK general election on May 7 could usher in weeks of political instability have sparked a sudden surge in negative bets on the FTSE 100. Last week saw £12 billion notional of put options traded on the FTSE - up a third on the previous week, according to UBS's equity derivatives strategy team - nudging the ratio of puts to calls traded on the index towards historical highs.

Current polls suggest neither the Conservative Party - which currently leads a governing coalition with the third-largest party, the Liberal Democrats - nor the opposition Labour Party will win an outright majority on election day. This means a second-successive hung parliament is likely, say analysts, making another coalition government, which could take weeks to form, a near certainty.

The other, less likely alternative – that one of the main parties will seek to form a minority government with informal support from nationalist or fringe parties – is less appealing to investors nervous about the prospects for their equity holdings since it could spell a period of long-term political instability.

"We haven't had a hung parliament that resulted in a minority coalition since late in the 1970s, so it's a big generational event that may transpire. It's important people are aware of that. There is a high level of incertitude on how to position trades on the back of this," says London-based Alexander Altmann, Emea head of equity trading strategy at Citi.

Investor uncertainty

Up until last week, hedging activity on the FTSE 100 had been muted, say dealers, with volumes relatively low compared to early forecasts. With such a fragmented election result long expected, several dealers had predicted institutional investors would seek structured hedges on their long UK equity exposure sooner.

As the run-up to the Scottish referendum last autumn showed, a currency can show volatility as and when major constitutional questions begin to be asked

The pattern of investor behaviour is the inverse of market moves seen in September 2014 in the run-up to the referendum on Scottish independence. Back then many firms sought downside protection on their UK equity holdings relatively early, but market data suggests those bets were largely unwound in the week preceding the vote.

FTSE volatility has also been relatively calm, at around 15% over the past three months – low in terms of what the market would normally price in for event risk, say dealers. Skew is also low compared to other international benchmarks, with a 3.8% difference between a 95 put and a 105 call, according to Bloomberg data, suggesting the market has not priced in protection against dramatic swings.

Anecdotal reports from structured products issuers and distributors also suggests a limited impact on demand in the run-up to the election, although some have sought to capitalise by offering products with downside protection on the FTSE 100.

Last month, Reyker launched an autocallable from RBC Capital Markets tied to the FTSE 100, with a look-back feature aimed at mitigating any sudden falls in the market during the first few months of the product term – coinciding with the UK general election and its aftermath.

Many in the market also take the view that the FTSE 100 is not the best proxy for calculating UK political risk, given 75% of its companies' revenues comes from overseas markets. As a result, several market players hedging for UK election protection have looked to other gauges, such as the value of sterling.

"On the forex market, the level of uncertainty that is priced in on the day or on the event is similar to, or a bit higher than, what we had last year for the Scottish referendum or even for 2010, so the market is at the margin a bit more nervous," says Fabrice Montagne, chief UK and senior European economist at Barclays.

Volatility rising

Volatility has increased sharply over the last few days leading up to the election, with one-week implied volatility for sterling/US dollar jumping to 17.82%, according to analysts at Citi.

Edinburgh-based Andrew Milligan, head of global strategy at Standard Life Investments, says the trends seen in autumn 2014 showed how political uncertainty can affect currency markets.

"As the run-up to the Scottish referendum last autumn showed, a currency can show volatility as and when major constitutional questions begin to be asked, and this experience was another reason why we, and many other investors, decided the pound – rather than, say, gilts or equities – was the better asset class to consider when analysing the potential impact of the UK election result," he says.

London-based Adam Cole, global head of forex strategy at RBC Capital Markets, suggests that while election risk has already been priced in, investors might get a surprise after the event, as the curve shows there has not been much hedging against volatility, which may arise if the resulting political consensus is deemed unstable or takes several weeks to form.

"If you look at one-month volatility – one month forward, for instance – it rapidly normalises once the election is out of the way," says Cole. "Just from the shape of the curve and what we're seeing in the spot market, I wouldn't say investors are worrying about the longer-term implications and I think they should be."

Trend away from UK equities

Regardless of the election result, a trend away from UK equities has already begun in earnest, with European equities emerging as the main beneficiary. The UK Investment Association reports that UK retail equity funds saw their largest ever net outflow of £963 million in March, with a heavy emphasis on switching into European funds.

Dealers suggest a similar move has begun in the institutional space. "What's interesting for equities is you have a better growth outlook in Europe, so you have a good alternative," says Barclays' Montagne.