dc.description.abstract | n the last two decades, modelling the term structure of interest rates and using the same
to re ect the monetary policy framework in the greater scal environment has attracted
interest among nancial markets players across the globe. Their interest has been the
economy, but broken down, it has been the di erent components in the nancial market
that include bonds, bills, mortgages and other forms of securities traded in the market. As
such, researchers have embarked on a serious review of the yield curve to model the term
structure of interest rates, due to its predictive power and forecasting capabilities of future
economic states in an economy.
The yield curve has been used over the years to predict and forecast among other economic
factors; in ations rates at di erent periods, real economic output, future possibility of
periods of recession, and also potential growth. The yield curve has been used in developed,
emerging, and developing economies successfully. However, it has been employed in developed
and emerging nancial markets than it has been in developing markets. Research
shows that the yield curve has been used to model interest rates in American markets;
including Colombian and Brazilian market, as well as emerging nancial markets like
South Africa and India.
Although the concept of forecasting is best discussed from an actuarial perspective, the
tenents of Finance and Mathematical Statistics provide very critical grounds for which to
begin and build on. Various models have been proposed, especially in the developed and
emerging markets. However, few research work has been done in the developing markets
that include the Kenyan nancial market. Over time, model-based asset pricing and its
evolution over the years to bring in modern day dynamics in nancial markets has become
extremely important. As such, nancial institutions o ering xed nancial instruments
have relied on estimations, modelling and forecasting to build scenarios and come up with
plausible and workable solutions to the uncertain environments they operate in, and the anticipation
of changes in future. As such, market players have opted to model term structures
of interest rates in predicting yields of nancial instruments/assets in the nancial markets.
The models that have been brought forward in the Kenyan context include the no-arbitrage
and equilibrium approaches. However,this study proposes a unique model; Nelson-Siegel
(1987). Further, this study considers a reparameterized form of the model called by Diebold
3
and Li (2006) which is an advancement of the Nelson-Siegel model. This is the model to
be employed to t Kenyan data. Additionally, the study considers the same model but
include time varying parameters of regression type. To the best of my knowledge, this
combination of models bringing in time varying parameters is one of its kind and the
rst to be conducted in the Kenyan scenario. The models of regression type will then
be used for forecasting and the results maybe compared with benchmarking models that
successfully worked in other application across the globe.
The term structure of interest rates is best demonstrated in yield curves. A yield curve
basically represents the relationship between yields of a nancial instrument (a bond in
our case) and their term, basically described as the maturity. The term structure basically
shows the behavior of interest rates in the short-term, medium-term and the long-term. It
is usually a plot of interest rates of bonds against maturity in months or years.
1.1 Concept of Bonds
Gwalani (2015) de nes a bond as a debt security instrument that is issued by companies
or government with an aim of raising money. A coupon bond pays regular instalments
and the principal on maturity date. Das, Ericsson and Kalimipalli (2012), notes that bonds
are means of raising funds for the government. Government bonds are instruments of
nancing a government de cit Ndung’u (2013). Bonds are tools of acquiring loans from
individuals and institutions. Bonds are a crucial means of getting funds by the governments.
These bonds range from short term to long term bonds depending on the purpose of the
bond issuance. Kabua (2011) noted that the rst world countries such USA, and European
Countries have the best and most complex bond markets.
Jaramillo and Weber (2013) avers that the bond statistics indicates that the world bond
market statistics is dominated by the developed countries. For instance America occupied
large share of the pie at about 40% of the world value of outstanding domestic bonds;
its market comprises mortgage-backed securities, Federal Agency Securities, Corporate
Bonds and treasury bills (Myers, 2014). In fact most of Africa’s debt is in foreign currency
and is therefore considered as not tradable, and very few countries in Africa have a viable
bond market. Particularly, for most African countries the bond market is insigni cant
or non-existent, even though Africa has some of the most heavily indebted countries
in the world (Yeboah, 2014). Sub-Saharan African countries in developing local bond
markets include the di erent debt structures and level of market infrastructure. Kenyan
government bonds are traded in the Nairobi security exchange market and have maturities
ranging from 1-30 years. The continued growth of the bond market is an indicator of the
critical role played by the bond market in raising capital for corporates and funds for the
government. | en_US |