A Comparative study on mathematical models for interest rate dynamics: a Kenyan case study
Maina, Hudson Mwangi
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This dissertation calibrates equilibrium one-factor short-term interest rate models to the evolution of interest rate dynamics in Kenya. The aim of the study is to find out which one-factor short-rate model best captures the dynamics of the short-term interest rate in Kenya. Additionally, the study aims to evaluate the relationship between conditional volatility of interest rate changes and the level of interest rate. The findings of this study provide a basis for valuation of contingent claims and hedging of interest rate risk. The data used in the study was obtained from the Central Bank of Kenya (CBK) website 1 for the period between January 2005 to July 2016. Since the short-term interest rate is unobservable in the market the 91-day Treasury Bill (TB) rate was used as its proxy. The Generalized Method of Moments (GMM) estimation technique was used to obtain the parameters for all the models under study. Key results showed that there is weak evidence of mean reversion for all the models evaluated. Furthermore, it was established that there exists a positive relationship between interest rate volatility and the level of interest rate. The best performing model from the study is determined to be the Chan, Karolyi, Longstaff and Sanders (CKLS) model which allows the volatility of interest rate changes to be highly dependent on the level of the interest rate. This model also has the best volatility forecasting ability among the models under study. It is therefore recommended to interest rate policy makers for use in their work.