Political Event Risk Raises Stakes for Sudden Price Movements

At a Glance

  • Rising political event risk could gyrate equity, FX, bond and ag markets

Political risk is rising – elections in Mexico, Brazil and the US; a leadership battle for the head of Liberal Democratic Party (LDP) in Japan; the US planning protectionist trade tariffs involving China, the European Union, Canada and Mexico; a looming Brexit deadline; shifting OPEC and Russian oil production tactics; among other risks.  With elections, Brexit, and OPEC, the dates are known and the outcomes unknown with very different scenarios.  The US initiated trade disputes ebb and flow, yet the different scenarios could move equity markets.

With rising political event risk comes an elevated risk for sudden price moves in markets in the spotlight.  The challenge for risk managers is that two very different, often opposite scenarios will be debated.  But when the event happens, such as an election, the outcome becomes immediately known and prices move quickly to reflect the prevailing scenario.  We have also seen this in equities with trade war rhetoric.  When the US threatens tariffs, equities can swoon, only to recover as tensions ease.  With several of the upcoming elections, such as in Mexico and Brazil, it is the currency markets that will react sharply to the outcomes.  And, in several trade cases, US agricultural will be the targets for tariff retaliation.

Options can be a very useful tool for event risk management.  One must remember, however, that calculations of implied volatility usually do not account for price gap risk (e.g., if they are based on a straightforward Black-Scholes model).  So, the calculated implied volatilities may include a premium for price gap risk on top of any expected shift in the volatility regime.  When the event date is known, then one may also study the differences in options prices and implied volatility calculations for options expiring before and after the event date to help ascertain how much event risk is present in a market.

Read more http://www.cmegroup.com/education/featured-reports/political-event-risk-raises-stakes-for-sudden-price-moves.html about event risk possibilities over the coming six to nine months.

Bluford (Blu) Putnam has served as Managing Director and Chief Economist of CME Group since May 2011. He is responsible for leading economic analysis on global financial markets by identifying emerging trends, evaluating economic factors and forecasting their impact. Prior to joining CME Group, Putnam gained more than 35 years of experience in the financial services industry with concentrations in central banking, investment research and portfolio management. He has authored five books on international finance.

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