Sterling is faring better than one would have
expected given that some polls suggest that the Tories could lose their
majority in Parliament in next week’s election. That said, in the
winner-take-all, first-past-the-post system in the UK, it is difficult to go
from the national opinion polls to the number of seats. The most
likely case according to five of the top six pollsters is that the Tories
secure a larger majority.
After falling four days last week, sterling appreciated in the first three
sessions this week and is essentially giving back yesterday’s gains today.
However, below the surface, things do not
appear as calm. Some market participants appear to be buying sterling
puts for protection.
Even if one does not use options, developments
there can help shed led on what is happening, and can assist in the price discovery process. Volatility has been
trending up since reaching a two-year low in the middle of May. The
three-month implied volatility has risen from about 6.82% to 8.5%. The
increase in volatility does not appear in
the historic (realized) volatility, which has been
flat near 8.25%-8.45%. That suggests that the increase in implied
volatility is coming from the demand for options.
We then look at the skew between puts and
calls. The skew has consistently favored puts over calls, but as sterling rallied this year, the put premium fell. On May 24 it was 0.24%, the smallest in several
years. It now stands at nearly 1.0%, a four-fold increase.
created on Bloomberg, shows the options
skew (three-month 25 delta risk reversal) in the white line, and sterling is the yellow line. The
takeaway is that the market appears to be more nervous than the relatively firm
sterling in the spot market
suggests. Typically, one might expect those with sterling exposure
to sell calls (and receive funds) rather than buy puts (new expenditure).
The buyers of puts might not be buying insurance as much as taking a punt on
the direction of sterling.