Brazilian Elections - 2nd Round: Huge Volatility And A Binary Situation

| About: iShares MSCI (EWZ)

Summary

The second round of Brazilian presidential elections will take place on October 26th.

The polls show that the chances of both candidates are tied.

The Brazilian stock market has experienced a huge level of volatility lately.

The result of the elections will be a binary event, with Brazilian equities gaping strongly up or down.

The 2nd round of Brazilian presidential elections will take place on October 26th. The opponents are the current Brazilian president Dilma Rousseff and the former Minas Gerais governor Aecio Neves. As I stated in my article a couple of weeks ago, Neves is strongly preferred by the financial markets because of his liberal market-friendly economic program. On the other hand the victory of Dilma Rousseff would lead to huge disappointment and selloff of Brazilian assets.

The Brazilian stock market (represented here by iShare MSCI Brazil Capped ETF (NYSEARCA:EWZ)) reacted positively on the results of the first round of elections where Aecio Neves finished second and received more than 33% of votes, beating the surveys. The Brazilian markets rallied strongly, led by shares of Cemig (NYSE:CIG) and Petrobras (NYSE:PBR). The gains were lost after a couple of days because of the uncertainty whether Marina Silva who finished 3rd in the first round with more than 20% of votes will support Neves.

EWZ Chart

EWZ data by YCharts

And it rallied again when Marina Silva supported him. But the markets erased most of the gains during the last three trading days when the polls showed that both of the candidates have virtually identical chance to win. The race will probably be tied up till the final day which may unnerve a lot of investors. Therefore there may be another round of sell-offs during the last trading days before the second round of elections.

The second round of elections itself represent a simple binary event. On Monday, October 27th, the markets will gap up or gap down. Based on who will be the next president.

Huge volatility

The Brazilian stock market has experienced a strong increase of volatility. The chart below shows volatility of iShares MSCI Brazil Capped ETF, Cemig, Petrobras and Vale (NYSE:VALE), during the last three months, measured by 10-day moving coefficients of variation.

Source: Own Calculations

As we can see the volatility of EWZ and Petrobras has doubled and the volatility of Cemig has increased more than 5-fold during the last couple of weeks.

This time the volatility related to the presidential elections is significantly higher compared to elections in 2010 and 2006, as shown by the chart below.

Source: Own Calculations

The chart shows volatility of EWZ measured by 10-day moving coefficients of variation during the last 75 trading days before the 2nd round of presidential elections in 2006, 2010 and 2014 (there are still 5 days remaining). The volatility during the last couple of weeks has been almost double compared to the last two elections.

The chart below shows returns of EWZ during the last 75 trading days before the 2nd round of elections in 2006, 2010 and 2014. Brazilian markets recorded double digit gains during this time period in 2006 as well as in 2010. But this time is really different. There is a significantly higher volatility (as shown above) and the index has recorded losses. This fact can be attributed to much worse state of the Brazilian economy, as well as questionable commodity markets outlook. The investors seemingly understand that a change in economic policies is needed, therefore they are more worried about the final result of the elections. This strengthens the impact of the binary event on the markets.

Source: Own Calculations

Conclusion:

The direction of the Brazilian markets will be impacted by the poll results during the last five trading days before the 2nd round of presidential elections. Polls suggesting a significant lead of Neves will result in a market rally, polls suggesting significant lead of Rousseff will lead to big slumps. Polls showing tied chances will probably encourage a lot of investors to sell their equities during Thursday and Friday in order to avoid risk of negative result.

A risky strategy that may pay off is long straddle. In this case it means buying November call options on EWZ with strike price of $45 and put options with strike price of $45. Although both of them are quite expensive right now and move of EWZ value by more than 16% is needed to gain some profit.

For more conservative investors it should be better to close their positions at the beginning of the election week and to reenter it according to the results of the elections. The less risk averse investors may consider opening or increasing their positions during late Friday trading.

Disclosure: The author is long CIG, PBR.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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