Working Paper: CEPR ID: DP2010
Authors: Sophie Coutant; Eric Jondeau; Michael Rockinger
Abstract: The aim of this paper is to compare various methods which extract a Risk Neutral Density (RND) out of PIBOR, as well as of Notional interest rate futures options, and to investigate how traders react to a political event. We first focus on five dates surrounding the 1997 snap election and several methods: Black (1976), a mixture of log-normals (as in Melik and Thomas (1997)), a Hermite expansion (as in Abken, Madan, and Ramamurtie (1996)), and a method based on Maximum Entropy (following Buchen and Kelly (1996)). The various methods give similar RNDs, yet, by allowing for somewhat dirty options prices, by providing a good fit to options prices, and by being fast, the Hermite expansion approach is the retained method for the data at hand. This approach also allows construction of options with a fixed time until maturity. A daily panel of options running from February 1997 to July 1997 reveals that operators in both markets anticipated the snap election a few days before the official announcement, and that a substantial amount of political uncertainty subsisted even a month after the elections. Uncertainty evolved with poll forecasts of who would form the future government.
Keywords: risk neutral density; futures option pricing; PIBOR; notional; political risk
JEL Codes: C52; E43; E52; G13; G14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Hermite polynomial approximation method (C60) | accuracy of the risk neutral densities extracted (C13) |
| polling forecasts (C53) | market uncertainty (D84) |
| government’s reassurances (H12) | market stability (D53) |