By Saikat Chatterjee and Olga Cotaga
LONDON (Reuters) - Sterling was well supported on Friday as investors rushed to unwind bets on a weaker pound after a resounding election victory for Prime Minister Boris Johnson's Conservative Party.
Johnson's win will allow him to end three years of political paralysis and take Britain out of the European Union in an orderly manner in a matter of weeks.
The pound was last trading up 1.1% at $1.3324 <GBP=D3>, giving up some of the gains it made overnight when it surged to a 19-month high of $1.3516. Against the euro, the pound was up 1.3% at 83.43 pence <EURGBP=D3>, having skyrocketed to a 3-1/2-year high of 82.78 pence.
It had jumped more than 2.5% after exit polls pointing to the scale of the Conservatives' win were published, making it at that time its biggest one-day gain in nearly three years.
This was a remarkable jump for a currency that has become extremely volatile since Britain voted to leave the EU in a referendum in 2016.
Vasileios Gkionakis, global head of FX strategy at Lombard Odier, said he had now sold sterling after increasing his holding in the currency when it was languishing at $1.26.
"From a risk-reward perspective it makes sense to take profit," he said.
But Gkionakis believes sterling could rise to $1.40 as there was a chance Johnson could now seek to extend the post-Brexit transition period beyond December 2020 in order to complete negotiations on a future trade deal with the EU. During the election campaign, the prime minister had pledged not to do this.
Moreover, with a strong majority in parliament, "Johnson will not rely on Eurosceptics to hold him hostage," Gkionakis said.
RATE CUT BETS SCALED BACK
Analysts from HSBC expect sterling to rise to $1.45 and to 76 pence against the euro by the end of next year, now that the "politically driven undervaluation" has been removed. It had previously forecast targets of $1.37 and 80 pence.
HSBC said that sterling will again be driven by economic data after years of being politically driven.
In the options market, the premium for pound puts over calls <GBP1MRR=> -- the right to sell pounds versus the right to buy them -- during the next week shrank to its lowest since mid-November at nearly 1.75%, a day after it reached its highest since September 2016.
That means fewer investors expect the pound to fall over the coming week.
Graphic - GBP risk reversals: https://fingfx.thomsonreuters.com/gfx/mkt/12/9939/9851/GBP%20risk%20reversals.png
On top of that, the three-month sterling implied volatility gauges, which include the Jan. 31 Brexit deadline, have fallen to a five-month high of 7.13 vol, suggesting traders have removed protection against unexpected moves in sterling. <GBP3MO=FN>.
Expectations of aggressive rate cuts by the Bank of England were also scaled back as investors bet the lifting of political uncertainty would prompt policymakers to take a more optimistic view of the economy.
"The potential for a smooth Brexit removes some of the downside risk for the UK economy, and this should be positive for both business and consumer confidence," said Guy Foster, head of research at wealth manager Brewin Dolphin.
Along with the pound, the mid-cap stocks index FTSE 250 <.FTMC>, which is home to many companies with high UK revenues, surged about 5% to record highs.
Britain's 10-year gilt yield also jumped to a six-month peak of 0.895% and was last up 3 basis points at 0.86% <GB10YT=RR>. The gap between Irish and German 10-year government bond yields shrank to its smallest since Jan. 2018 <DE10IT10-RR>.
(Reporting by Saikat Chatterjee; Editing by Toby Chopra)