Public domestic debt optimization and the term structure of interest rates - Dynamic Nelson Siegel Approach
Munene, Anne Keru
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In this study, Markowitz's mean-variance optimization approach is applied to Kenya's public debt portfolio to identify the optimal domestic debt portfolio. The study first adopts the Dynamic Nelson Siegel model to parameterize the yields only model of the Term Structure of Interest rates in Kenya between March 20 l 0 and October 2014. This is done so as to account for the importance of elaborate interest rate models in incorporating interest rate uncertainty. The expected interest rate cost is estimated based on the yield curve dynamics as established under the Dynamic Nelson Siegel framework. The optimization scheme adopted minimizes interest rate cost and variance of the different bonds across the different maturities subject to the constraints of no short sales, sufficient liquidity and a sufficient portion is allocated to long term maturities to cater for long term development projects. The results indicate that the optimized bond portfolio is in favour of medium to long dated bonds in order to reduce the overall risk level.