Modelling Volatility of Short-term Interest Rates in Kenya

Abstract

There is an extensive theoretical and empirical literature that documents the link between short-term interest rate volatility and interest rate levels. This study sought to establish the link between the level of interest and the volatility of interest rates in Kenya using the Treasury bill rates from August 1991 to December 2007. The main variable for the study was the short term interest rate series. In Kenya, this is the Central Bank three-month Treasury bill rate. The interest rate volatility was studied using the general specification for the stochastic behaviour of interest rates which is nested in a Stochastic Differential Equation (SDE) for the instantaneous risk free rate of interest as earlier defined by Chan et al. (1992). The study applied the monthly averages of the 91-day T-BILL rate for the period between August 1991 and December 2007 which were obtained from the Central Bank of Kenya. The results of the study were consistent with the hypothesis that the volatility is positively correlated with the level of the short term interest rate as documented by previous empirical studies. The key findings revealed that there exists a link between the level of short-term interest rates and volatility of interest rates in Kenya. Secondly, the study‟s key findings revealed that the GARCH model is better suited for modelling volatility of short rates in Kenya, as opposed to ARCH models. The study further establishes that GARCH models are able to capture the very important volatility clustering phenomena that has been documented in many financial time series, including short-term interest rates. The study recommends future research to examine if other forms of the GARCH process can produce similar results (i.e., EGARCH, PGARCH, GARCH, and FIGARCH).