Two months to go and sterling election risks confined to options

* Sterling trade-weighted index at 6-1/2 yr high

* Hedge funds betting on sterling drop in options market

* Volatility around elections and post-results seen rising

By Anirban Nag

LONDON, March 9 (Reuters) - Less than two months before a deeply uncertain British general election, the pound stands at a six-year high, suggesting investors are ignoring political risks to holding the currency.

Sterling's rise to its highest against a currency basket since September 2008 is mainly caused by the weakening of the euro as the European Central Bank begins its bond-buying programme on Monday. Robust data has also helped lift sterling, with investors pricing in a chance of a rate hike in early 2016

Sterling's gains, though, mask significant hedging and speculative bets against the pound in the derivatives market. The cost of hedging against sharp swings in the pound against the dollar and euro around the time of the election -- in May and June -- have risen to double digits.

"Although the recent spot price action does not suggest market concerns about the election risk and the build-up of the risk premium, this is not the case in the option market, which has been heavily pricing in political risk premium," said Petr Krpata, currency analyst at ING.

Hedge funds, for example, are taking no chances, unlike last year. Many were caught napping before the Scottish independence vote in September, which triggered a massive bout of volatility and a decline in the pound. Now (NYSE: DNOW - news) they are buying options, betting on sterling weakness.

The three-month implied volatility for sterling/dollar trades at just over 10 percent, compared with 9.5 percent for the six-month and 9.4 percent for nine-month options.

The two- and three-month risk reversals, a gauge of demand for options on a currency rising or falling, are showing more bias for sterling weakness against the dollar.

"We are buying three-month sterling/dollar downside options," said Howard Jones, partner at RMG Wealth, a manager of global macro and foreign exchange strategies. "The UK has been drawing investments because of political stability. That might not be the case after May."

NECK AND NECK

Opinion polls show the ruling Conservative Party and the opposition Labour neck-and-neck, making a hung parliament a strong likelihood after the May 7 vote.

At the same time, the Scottish National Party, the party that campaigned to split Scotland from the United Kingdom, is seen making inroads and might enter a coalition, keeping alive the prospect of a break-up. The election will also decide whether the UK holds a referendum on European Union membership.

Despite these, sterling trades at more than seven-year highs against the euro and recently hit an eight-week high against the dollar, before falling.

"This election is very uncertain, and while sterling's correlation historically to previous elections has not been strong, this time it could be different," said Richard Falkenhall, currency strategist at SEB (Paris: FR0000121709 - news) . "We think the uncertainty created will see sterling lose ground in coming months."

Recent elections have been a bit more predictable, bolstering Britain's position as a safe haven for investment. ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^ GRAPHIC ON PAST UK ELECTION, SCOTTISH VOTE AND STERLING http://fingfx.thomsonreuters.com/2015/03/09/115938651c.htm ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^

Investor (Other OTC: IVSBF - news) concerns include the prospect of heavier spending, higher taxes, financial-sector regulation by a centre-left Labour-led government and the possibility of Britain's leaving the European Union under the Conservatives, who have pledged a referendum on membership within two years.

Daragh Maher, a strategist at HSBC, said in a note that a Conservative-led government could see sterling come under selling pressure before any EU referendum. And any relief that a Labour-led coalition with the Scottish National Party would not seek an EU referendum could prove short-lived.

"An additional downside for sterling is that the SNP's prominent role in government could raise fresh concerns about the likely longevity of the United Kingdom, and the prospect of a new referendum on Scottish independence," he wrote. (Reporting by Anirban Nag, graphics by Vincent Flasseur; Editing by Larry King)