Reading Interest Rate and Bond Futures Options' Smiles : How Pibor and Notional Operators Appreciated the 1997 French Snap Election

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 5 dates surrounding the 1997 snap election and several methods: Black (1976), a mixture of lognormals (as in Melik and Thomas (1997), an 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, the Hermite expansion approach, by allowing for somewhat dirty options prices, by providing a good fit to options prices, and by being fast is the retained method for the data at hand. This approach also allows construction of options with a fixed time till 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 polls' forecasts of the future government