Investors brace for sterling election risk, mindful of Scotland vote

* Sterling six-month implied volatility hits 2-1/2-year high

* EU referendum adds political risk premium for pound

* Investors wary after Scottish referendum volatility

By Jemima Kelly

LONDON, Jan 14 (Reuters) - Currency investors have begun to protect themselves against the risks to sterling posed by the most uncertain British election for decades, having learnt a tough lesson in the run-up to Scotland's independence referendum.

Sterling fell sharply and volatility soared in the days preceding September's vote as investors belatedly woke up to the possibility that Scotland could break away from the rest of Britain, harming the economy and investment.

"They got burned," said Marvin Barth, European head of currency strategy at Barclays (LSE: BARC.L - news) . "They learned that politics are important."

This time, insurance against violent price swings is being put in place well before May 7's parliamentary vote.

Six-month sterling/dollar implied volatility, the premium to hedge with an option that covers the election period, has risen sharply, outstripping an increase in euro/dollar implied volatility by hitting 9.6 percent last week. That was its highest since June 2012 and marked a rise from around 7.7 percent a month ago. http://link.reuters.com/nuz73w

"Volatility around the election has been bid up but I think maybe not enough as yet," said Graham Davidson, a spot trader at National Australia Bank in London.

Political risk is already weighing on sterling.

It hit an 18-month low of $1.5034 last week as investors began to price in the risks of another, potentially fractious, coalition government and a future referendum on Britain's membership of the European Union.

A key election issue is the traditionally dominant Conservative and Labour parties' differing approaches to Britain's big budget deficit. The Conservatives propose deep spending cuts to generate a surplus by 2018/19 while Labour plans a mix of cuts and tax rises to balance the budget during the next five-year parliament.

Polls suggest a third of the electorate intends to vote for other parties, however, most conspicuously the anti-EU UKIP. Goldman Sachs (NYSE: GS-PB - news) reckons the outcome of the election is the least certain in 100 years.

Two opinion polls this week underlined this unpredictability: one gave the Conservatives a six-point lead with 34 percent of the vote, while the other put Labour five points ahead on 37 percent.

That raises the prospect of days or weeks of wrangling as two or more parties try to forge a coalition -- a period investors believe will be volatile and damaging for sterling.

"When there's fog, and investors can't see through it ... you get a risk premium," said Savvas Savouras, chief economist at hedge fund firm Toscafund. "Risk premiums suppress the value of a currency."

ONCE BURNED TWICE SHY?

It is not just the immediate aftermath of the vote that is unclear, and that makes calculating an appropriate risk premium for sterling more difficult.

Ian Gunner, a currency fund manager at Altana Wealth, said the biggest political risk for the pound was a referendum on EU membership promised by the Conservatives by 2017 if they are returned to power.

Nine-month and one-year sterling/dollar implied volatility, which captures price action up to October and January respectively, has also spiked to almost two-year highs, as investors worry that a vote to leave the EU would hurt the economy and drag down sterling.

"I'm not sure the uncertainty is cleared up by the election because the bigger uncertainty is the EU referendum and that's still outstanding," Gunner said. "This is the first stage of a two-stage process."

Another looming risk is that the Scottish National Party, whose support in Scotland has surged at the expense of Labour, may seek a second referendum on independence as the price for joining any coalition.

"The Scottish referendum itself changed the dynamic and the likely risks that one faces in the May election," said Barth at Barclays. (Additional reporting by Patrick Graham; Graphic by Nigel Stephenson; Editing by Catherine Evans)