Construction of a zero-coupon yield curve for the Nairobi Securities Exchange and its application in pricing derivatives
Yield curves are used to forecast interest rates for different products when their risk parameters are known, to calibrate no-arbitrage term structure models, and (mostly by investors) to detect whether there is arbitrage opportunity. By yield curve information, investors have opportunity of immunizing/hedging their investment portfolios against financial risks if they have to make an investment with some determined time of maturity. Private sector firms look at yields of different maturities and then choose their borrowing strategy. The differences in yields for long maturity and short maturities are an important indicator for central bank to use in monetary policy process. These differences may show the tightness of the government monetary policy and can be monitored to predict recession in coming years. A lot of research has been done in yield curve modeling and as we will see later in the thesis, most of the models developed had one major shortcoming: non differentiability at the interpolating knot points. The aim of this thesis is to construct a zero coupon yield curve for Nairobi Securities Exchange, and use the risk- free rates to price derivatives, with particular attention given to pricing coffee futures. This study looks into the three methods of constructing yield curves: by use of spline-based models, by interpolation and by using parametric models. We suggest an improvement in the interpolation methods used in the most celebrated spline-based model, monotonicity-preserving interpolation on r(t). We also use operator form of numerical differentiation to estimate the forward rates at the knot points, at which points the spot curve is non-differential. In derivative pricing, dynamical processes (Ito^ processes) are reviewed; and geometric Brownian motion is included, together with its properties and applications. Conventional techniques used in estimation of the drift and volatility parameters such as historical techniques are reviewed and discussed. We also use the Hough Transform, an artificial intelligence method, to detect market patterns and estimate the drift and volatility parameters simultaneously. We look at different ways of calculating derivative prices. For option pricing, we use different methods but apply Bellalahs models in calculation of the Coffee Futures prices because they incorporate an incomplete information parameter.