Political risk and market efficiency: Tests based in British stock and options markets in the 1987 election

Abstract

This paper examines the behaviour of the stock and options markets in London during the 1987 election. We find an extremely close relationship between opinion polls and the FTSE 100 Index of share prices. However, in the last week of the election the options prices showed evidence of gross inefficiency: they implied a decreasing probability of a Conservative win while the polls indicated the opposite. The inefficiency was sufficiently large for a volatility arbitrage to be feasible, net of transactions costs. These two tests appear to indicate that a speculative bubble was present in the options.