Reading PIBOR Futures Options Smiles: the 1997 Snap Election

M. ROCKINGER, S. Coutant, E. Jondeau

Journal of Banking and Finance

November 2001, vol. 25, n°11, pp.1957-1987

Departments: Finance

Keywords: Risk neutral density, Interest rate, Implied volatility, Election

In this paper, we compare various methods that extract a Risk Neutral Density (RND) out of PIBOR interest-rate futures options and we investigate how traders react to a political event. Our benchmark model derives from A. Brace, D. Ga¸tarek, M. Musiela [Mathematical Finance 7 (1997) 127–155]. We also consider a mixture of log-normals (as in W.R. Melik, C.P. Thomas, Journal of Financial and Quantitative Analysis 32 (1997) 91–116), an Hermite expansion (as in P. Abken, D.B. Madan, S. Ramamurtie, Estimation of risk-neutral and statistical densities by Hermite polynomial approximation: with an application to Eurodollar Futures Options, Federal Reserve Bank of Atlanta, 1996), and a method based on Maximum Entropy (according to P. Buchen, M. Kelly, Journal of Financial and Quantitative Analysis 31 (1996) 143–159). We take care of the early exercise feature and we show how to approximate RNDs for a fixed time to maturity. The various methods generate similar RNDs. A daily panel of options running from February 1997 to July 1997 reveals that operators expected the snap election a few days before the official announcement was made and that a substantial amount of political uncertainty subsisted even a month after the elections. Uncertainty evolved with polls forecasts of the future government