Calibration of vasicek model in a hidden markov context: the case of Kenya
Chelimo, John Kigen
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This dissertation calibrates the Vasicek term-structure model to the evolution of interest rate dynamics in Kenya. This is done for both a single-state and a multi-state model using state estimated under a Hidden Markov Model (HMM). The findings of this paper provide a starting point for the management of the risk posed by interest rate-dependent instruments.The Vasicek model is calibrated using monthly observations of the 91-day treasury bill rate from September 1994 to July 2014 as a proxy for the short rate. Key results show an increase in the mean reversion parameter with an increase in the number of states, suggesting higher stability of states. The volatility is observed to move independently of the level of the interest rate,supporting the idea that risk is not necessarily a function of the level of the interest rate but rather related to the inherent variability of rates in a particular state. Findings from this parameter estimation provide support for interest rate models that incorporate regime switches.