THE VALUATION OF FOREIGN CURRENCY OPTIONS IN KENYA

UNDER STOCHASTIC VOLATILITY

BY: KAMBI ROBINSON
MUNENE D61/63201/2011
A Mana!"!n# R!$!a%&' P%()!&# S*+",##!- In Pa%#,a. F*./,.."!n# (/ #'!
R!0*,%!"!n#$ /(% #'! D!%!! (/ Ma$#!%$ (/ B*$,n!$$ A-",n,$#%a#,(n 1MBA23
S&'((. O/ B*$,n!$$3 Un,4!%$,#5 O/ Na,%(+,
NOVEMBER 2013
DECLARATIO
N
This research project is my original work and has not been submitted for the award of a degree at any
other university.
Signed Date.
Kambi Robinson unene. Registration
!umber" D#$%#&'($%'($$.
This research project has been submitted for e)amination with my approval as a *niversity of
!airobi supervisor.
Signed.Date.
Dr. +duda ,osiah -. Senior .ecturer.
School of /usiness0 *niversity of !airobi.
DEDICATIO
N
1 dedicate this research project to my loving family2 my mother and three sisters all of whom have
been a source of great inspiration in all my endevours.ay the +lmighty 3od bless them abundantly.
ACKNO6LEDGEMENT
S
1 would first like to acknowledge my supervisor Dr.,osiah - +duda whose guidance0 input and insight
has enabled me complete the research project. 1 am particularly grateful for his patience0 insightful
comments and advice throughout the entire process the project. 1 would also like to acknowledge my
moderatorr.wangiirie for the helpful and insightful input and comments all of which were very
important in conducting this research project.
1 would also like to acknowledge the contribution made by r.Tirop of 4entral /ank of Kenya in this
project0 1 especially acknowledge him for the ade5uate and helpful assistance that he gave me in the
certification of the secondary data that 1 used.
.astly 1 would like to acknowledge the *niversity -f !airobi asters -f /usiness +dministration
6/+7 for the assistance they gave me throughout the whole process of coming up with this project
and without forgetting /+ students *niversity of !airobi for the constructive criticism and insight.
ay 3od bless you all.
ABSTRAC
T
The main objective of this research project is to show how foreign currency options can be valued in
Kenya under stochastic volatility and also to come up with a model for predicting variance and
volatility of e)change rates. 8irst the research sought to develop a model for predicting variance based
on the *SD and Kenya Shillings e)change rates in Kenya for a period of five years between '((9:
'($'.The research also sought to show how foreign currency options would be priced information
from the available data.
This research used descriptive research design and the 3arman Kohlhagen model for valuation of
foreign currency options. The research uses 3arch 6$0 $7 model to fit the variance regression line
which was used to predict variance and subse5uently the volatility that together with other variables
isplugged into the 3arman Kohlhagen model. to price the foreign currency options.
The research gave findings that were consistent with research done in the area of valuation of foreign
currency options. The research shown that foreign currency options can be valued in Kenya by use of
a 3arch 6$0 $7 framework which was a good fit for the actual data as the coefficients of the model
were within the model constraints of 6; 0.987 <$ for using 3arch 6$0 $7 .The research found out that
for call options when the spot e)change rate is below the strike price the option has statistically =ero
value and when above strike price the option has a positive value. -n the other hand the price of a put
currency option is positive when the spot e)change rate is below the strike price and statistically =ero
when the spot e)change rates are above the strike prices and the further away from the strike price the
spot e)change rate is the higher the value of the option.
ABBREVIATION
S
+T.. +t:the:money +R4>.+uto Regressive
4onditional >eteroscedasticity /+:?.. /arone +desi ?haley odel.
/:S../lack Scholes odel. 4+...4apital arkets
+uthority. 3+R4>.3enerali=ed +utoregressive 4onditional
>eteroscedasticity 3/@.3reat /ritain @ound 1T..
..1n:the:money ,@A..,apanese Aen. !SB
!airobi Securities B)change. -T4-ver the 4ounter.
-T -ut:the:money @>.C .@hiladelphia Stock
B)change RB1TSReal Bstate 1nvestments Trusts.
*SD*nited States Dollar.
TABLE
S
Table $odel Summary.
Table '4oefficients. Table
&.. Strike price at D(. Table
E Strike price at 9(. Table
F Strike price at G(. Table
# Strike price at $((.
TABLE OF CONTENT
S
DECLARATION .............................................................................................................
................. i
DEDICATION.................................................................................................................
.................ii ACKNO6LEDGEMENTS
.............................................................................................................iii
ABSTRACT....................................................................................................................
.................iv
ABBREVIATIONS...........................................................................................................
................v TABLES
.....................................................................................................................................
.....vi CHAPTER
ONE..............................................................................................................................
.1 INTRODUCTION
............................................................................................................................1
1717 Ba&8%(*n- (/ #'! S#*-5....................................................................................................1
171717 Ca9,#a. Ma%8!# ,n K!n5a an- F(%!,n C*%%!n&5 O9#,(n$...........................................3
1727 S#a#!"!n# (/ #'! P%(+.!"...................................................................................................5
1737 R!$!a%&'
O+)!&#,4!$...........................................................................................................7
17: S,n,/,&an&! (/ #'! S#*-5 ....................................................................................................7
CHAPTER
T6O.............................................................................................................................
.9 LITERATURE REVIE6
.................................................................................................................9
271
In#%(-*&#,(n.......................................................................................................................9
272 R!4,!; (/
T'!(%,!$...........................................................................................................10
27271 B.a&8<S&'(.!$ M(-!..................................................................................................10
27272 Ga%"an an- K('.'a!n "(-!..................................................................................12
27273 B,n(",a. (9#,(n 9%,&,n "(-!...................................................................................13
273 R!4,!; (/ E"9,%,&a. S#*-,!$.............................................................................................15
27: C(n&.*$,(n /%(" .,#!%a#*%! %!4,!;....................................................................................21
CHAPTER
THREE........................................................................................................................2
3 RESEARCH
METHODOLOGY....................................................................................................23
371
In#%(-*&#,(n.....................................................................................................................23
372 R!$!a%&' -!$,n
...............................................................................................................23
373
P(9*.a#,(n........................................................................................................................23
37: Sa"9.!
.............................................................................................................................24
37= Da#a C(..!&#,(n
................................................................................................................24
376 Da#a Ana.5$,$
...................................................................................................................24
37> C(n&!9#*a. "(-!.
............................................................................................................25
37? E"9,%,&a. "(-!.
...............................................................................................................2
5
37@ Da#a Va.,-,#5 A R!.,a+,.,#5
....................................................................................................27 CHAPTER FOUR
..........................................................................................................................28
DATA ANALYSIS AND PRESENTATION
...............................................................................28
:71 In#%(-*&#,(n
.................................................................................................................28
:72 Da#a P%!$!n#a#,(n
.........................................................................................................28
:7271 Va%,an&!
...................................................................................................................28
:7272 S0*a%!- .( R!#*%n$ .................................................................................................28
:7273 R,$8 /%!! %a#!
............................................................................................................29
:727: S#%,8! 9%,&!
...............................................................................................................29
:727= T,"! #( "a#*%,#5.......................................................................................................30
:7276
V(.a#,.,#5...................................................................................................................30
:73 R!%!$$,(n %!$*.#$ ana.5$,$ an- a99.,&a#,(n (/ "(-!.7...................................................31
4.4 Summary and Interpretation of
Findings............................................................................37 CHAPTER
FIVE............................................................................................................................3
9 SUMMARY3 CONCLUSIONS AND RECOMMENDATIONS
..................................................39
=71
S*""a%5......................................................................................................................39
=72 C(n&.*$,(n$
..................................................................................................................40
=73 P(.,&5 R!&(""!n-a#,(n$..............................................................................................41
=7: L,",#a#,(n$ (/ #'! S#*-5 ...............................................................................................42
=7= S*!$#,(n$ /(% F*%#'!%
S#*-,!$....................................................................................43
REFERENCES................................................................................................................
...............44 APPENDICES
................................................................................................................................49
CHAPTER ON
E
INTRODUCTION
1717 Ba&8%(*n- (/ #'! S#*-5
4urrency options are derivative financial instrument where there is an agreement between two parties
that gives the purchaser the right0 but not the obligation0 to e)change a given amount of one currency
for another0 at a specified rate0 on an agreed date in the future. 4urrency options insure the purchaser
against adverse e)change rate movements. +ccording to i)on 6'($$7 foreign e)change option
markets were active during and after the 8irst ?orld ?ar where call options on 3erman marks were
the dominant instrument0 but calls on 8rench francs0 1talian lira0 and other currencies also traded. The
largest clientele for the options consisted of optimistic investors of 3erman heritage. 1nitially there
were fi)ed e)change rate regimes in operation and hence this limited growth of the foreign currency
options market.
Trading in foreign currency options began in $GD(Hs and $G9(Hs in listed futures and options market of
4hicago0 @hiladelphia and .ondon but from $GG(Hs the trading in foreign currency options shifted to
the over the counter market.?hile options on foreign currencies are traded on several organi=ed
e)changes0 li5uidity in currency options trading is predominant in 6-T47 market. .i5uidity in
currency options trading is centered in 6-T47 market. 1n fact0 according to al= 6$GG970 the prices of
-T4 currency options provide a better e)pression of changing views of future e)change rates than do
prices of e)change traded currency options. +ccording to 4hance 6'((97 the currency options are
therefore a useful tool for a business to use in order to reduce costs and increase benefits from having
increasing certainty in financial transactions that involve currency conversions.
1n pricing of foreign currency options there are various terms as defined in ?elch 6'((G7 "8irst a
derivative financial instrument as a financial instrument that derives its value from an underlying
asset which in foreign currency options is the e)change rate0 there are two types of foreign currency
options a call currency option and a put currency option. + call optionon a particular currency gives
the holder the right but not an obligation to buy that currency at a predetermined e)change rate at a
particular date and a foreign currency put option gives the holder the right to sell the currency at a
predetermined e)change rate at a particular date. The seller or writer of the option0 receives a
payment0 referred to as the optionpremium0 that then obligates him to sell the e)change currency at
the pre specified price known as the strike price0if the option purchaser chooses to e)ercise his right to
buy or sell the currency. The holder will only decide to e)change currencies if the strike price is a
more favorable rate than can be obtained in the spot market at e)piration.
8oreign currency options can either be Buropean style that can only be e)ercised on the e)piry date or
+merican style that can be e)ercised at any day and up to the e)piry date .8oreign currency options
can either be traded in e)change markets which occur in developed financial markets that have an
option market or be traded over the counter. -ver the counter traded foreign currency options are
better for they can be customi=ed further to offer more fle)ibility. The majority of currency options
traded over the counter 6-T47 are Buropean style. The date on which the foreign currency option
contract ends is called the e)piration date. 4urrency options can be at the money 6+T7 where
currency options have an e)ercise price e5ual to the spot rate of the underlying currency0 in the money
61T7 where currency options may be profitable0
e)cluding premium costs0 if e)ercised immediately or the foreign currency options may be -ut the
money 6-T7 options would not be profitable0 e)cluding the premium costs0 if e)ercised.
+ccording to Kot=He 6'($$7 the holder of a call option on a currency will only e)ercise the option if
the underlying currency is trading in the market at a higher price than the strike price of the option.
The call option gives the right to buy0 so in e)ercising it the holder buys currency at the strike price
and can then sell it in the market at a higher price. Similarly0 the holder of a put option on a currency
will only e)ercise the option if the spot currency is trading in the market at a lower price than the
strike price. The put option gives the right to sell0 so in e)ercising it the holder sells currency at the
strike price and can then buy it in the market at a lower price. 8rom the point of view of the option
holder0 the negative profit and loss represent the premium that is paid for the option. Thus0 the
premium is the ma)imum loss that can result from purchasing an option.
171717 Ca9,#a. Ma%8!# ,n K!n5a an- F(%!,n C*%%!n&5 O9#,(n$
+ccording to +loo 6'($$7 in the emerging markets capital account liberali=ation has increased
currency e)posures of both domestic and foreign entities. The demand for instruments to manage the
currency risk associated with portfolio investment0 as well as foreign direct investment0 is e)panding
5uickly. 1n Kenya the capital account has been liberali=ed hence leading to increased currency risk
e)posure hence the need to develop an appropriate foreign currency option pricing framework so as to
provide an additional tool to hedge against this risk. 4urrency options have
gained acceptance as invaluable tools in managing foreign e)change risk and are e)tensively used and
bring a much wider range of hedging alternatives as a result of their uni5ue nature.
The capital market in Kenya is regulated by the capital markets authority 64+7 which is an
independent public agency that was established in $G9G.The capital market in Kenya is composed of
the primary and secondary market. The primary market the e5uity market that offers trading in shares
through the !airobi securities e)change 6!SB7.The secondary market debt financial instruments like
treasury bonds0 corporate bonds0 preference shares0 infrastructure bonds. The derivatives market in
Kenya is still at its infant stage of development. The 64+7 is undertaking major reforms in the
capital markets to introduce financial instruments of hybrid -T4 bond trading. There is an ongoing
drive to introduce the derivatives and commodities futures in Kenya and also real estateHs investments
trusts 6RB1TS7 are being introduced. The securities and investment bill '($$ seeks to provide
additional framework necessary for the introduction of all these additional financial instruments.
+loo 6'($$7 in his e)ploratory study of currency options in the Kenyan financial market with a
specific focus on the use or lack of use of currency options in the Kenyan financial market found out
that currency options markets did e)ist in Kenya but only to a limited e)tent as only E.$I of
respondents said that the commercial banks they worked for offered currency options as one of their
treasury products. Twenty three percent of respondents attributed the slow growth of a currency
options market to low risk appetite by Kenyan commercial banks. There e)isted demand from clients
to support the growth of a currency option market as F#I of the respondents said they had received
in5uiries for currency options.
The Kenya shilling is usually very volatile hitting highs of $(D as it did in -ctober '($$ whereas it
has also hit lows of #$ in '((9.ost of the trading in imports and e)ports involve the dealing with the
*SD and hence development of foreign currency options market will enable hedge against foreign
e)change risk. ost of the trading in currency options in Kenya today is -T4 by various commercial
banks like the Kenya commercial bank and 4ommercial bank of +frica offer currency options but on
a limited scale. *nderstanding the valuation of currency options will be important in development of
an efficient currency options market in Kenya.
1727 S#a#!"!n# (/ #'! P%(+.!"
There are two views in pricing of foreign currency options. -ne assumes that the volatility used in the
valuation of currency options is known and is constant and the other argues that volatility is
stochastic. 3arman and Kohlhagen 6$G9&7 developed a variation of 6/:S7 used in the valuation of
currency options. /lack and Scholes 6$GD&7 developed the landmark paper in valuation of options.
ost of pricing models today seek to rela) the assumptions made by /lack and Scholes 6$GD&7 and
most focus on stochastic volatility develop a model for predicting volatility which is then plugged into
the 6/:S7 model and 3arman Kohlhagen odel.
Jarious studies have been done in Kenya relating to derivatives but most of the studies done so far
have been e)ploratory in nature0 +laro 6$GG97 studied the conditions necessary for the e)istence of a
currency options market in Kenya. >is study analy=ed the conditions necessary for the operation of
currency options by reviewingavailable literature. >e concluded that main conditions for an options
market to e)ist were a growing economy0 supported by the 4entral /ank of Kenya0 a fairly
independent e)change rate mechanism0 market li5uidity and
efficiency0 a regulatory organi=ation and a strong and developing banking system. The study
recommended the strengthening of the regulatory framework to provide clear guidelines as to the
operation of currency option markets.
+loo 6'($$7in his e)ploratory study of currency options in the Kenyan financial market with a
specific focus on the use or lack of use of currency options in the Kenyan financial market. The study
found that currency markets did e)ist in Kenya but only to a limited e)tent as only E.$I of
respondents said that the commercial banks they worked for offered currency options as one of their
treasury products. Twenty three percent of respondents attributed the slow growth of a currency
options market to low risk appetite by Kenyan commercial banks. There e)isted demand from clients
to support the growth of a currency option market as F#I of the respondents said they had received
in5uiries for currency options.-rina 6'((G7 in a survey to a survey of the factors hindering the trading
of financial derivatives in the !SB found out that there e)isted factors of lack of ade5uate regulation
and lack of ade5uate demand that hindered the trading of financial derivatives at !SB.
1n Kenya few researches have been done in the area of foreign currency options and the ones that
have been done are e)ploratory in nature. This research seeks to fill this research gap and show how
foreign currency options can be priced in Kenya. This research will important especially now that
derivativesH trading is being introduced in Kenya and it will offer useful insights into foreign currency
options pricing.
1737
R!$!a%&' O+)!&#,4!$
This research seeks to achieve the following key research objectives"
$. To develop an appropriate model for predicting volatility of *SD%KS>S e)change rate.
'. To conduct variance analysis for *SD%KS>S foreign currency options.
&. To value foreign currency options in Kenya using the predicted volatility values.
17: S,n,/,&an&! (/ #'! S#*-5
The research into valuation of foreign currency options in Kenya is very important in hedging against
foreign e)change risk e)posures. 8oreign currency e)change rates in Kenya are unpredictable and are
not stable due to the opening up of the foreign e)change market by the central bank. The e)change
rates are determined by the market hence foreign currency options will be of 1mportance to the
following" This research will use the *SD%KS>S e)change rates.
The first are the importers who have to pay for their imports in the foreign currency and by the use of
the pricing framework brought by this foreign currency options pricing. >ere the importers can first
buy a call option on the foreign currency which gives the importer the right to buy the foreign
currency at a certain fi)ed price. *nder if the Kenya shilling depreciates against the *SD the importer
e)ercises the call option to cover the downside risk and on the other hand if the Kenya shilling
appreciates against the *SD the importer will e)ercise the put option then he can sell the currency in
the market at a higher rate and earn a profit.
B)porters on the other hand usually receive the payment for their e)ports in foreign currency
e5uivalent of their Kenya shillings price and here they can buy some call and put options.
?hereby if the Kenya shilling appreciates against the *SD they will e)ercise the call options to cover
the downside risk and if the Kenya shilling depreciates they will e)ercise the put options on the *SD
so as to gain a profit.
/anks also will find this pricing framework very important as they will be able to offer new financial
instruments to their customers to hedge against foreign e)change risk by selling both call and put
options on various currencies. >ere the banks will be able to also hedge their downside risk relating to
foreign currency and also profit at the same time.
CHAPTER T6
O
LITERATURE REVIE6
271 In#%(-*&#,(n
This chapter seeks to analy=e the literature relating to foreign currency options pricing. The chapter
will have three broad areas where various theories of foreign currency options will first be analy=ed.
The chapter will show how the pricing of foreign currency options has evolved by analy=ing three
theories of /lack and Scholes 6$GD&7 model0 3arman and Kohlhagen 6$G9&7 model and the binomial
option pricing model. -nce the various theories of foreign currency option pricing have been
analy=ed empirical studies will then be analy=ed showing clearly findings of various researchers who
have ventured into the area of foreign currency option valuation.
The chapter will show clearly the various empirical findings done by the researchers in this area of
foreign currency option pricing. The chapter will show clearly the different researches done and how
they differ from each other and also show the similarities of the various studies done by different
researchers. The evolution of the research into the area of foreign currency pricing will be clearly
stipulated showing how the valuation of foreign currency options has evolved from the seminal paper
to date. Then finally the chapter will offer a conclusion that can be drawn from the literature review
showing what are the major themes of the literature on pricing of foreign currency options. ajor
contestations will also be spelt out in the literature review and research gaps identified.
272
R!4,!; (/ T'!(%,!$
K d
$
LM
T ..............................................6 vi 7M T
27271 B.a&8<S&'(.!$ M(-!.
/lack and Scholes 6$GD&7 developed 6/:S7 odel and suggested the following stochastic differential
e5uation as a model for the dynamics of a stock price process"


. 6i) ?here St is the stock price at time
t0 is the return on the stock and is the volatility of the stock0 defined as the standard deviation of the
log returns and Wt is a standard /rownian motion. The first term of the right hand side is called the
drift. 1t is the deterministic part of the e5uation0 and contributes to driving the process value St in a
deterministic way. The second part0 called the diffusion0 is the stochastic part. 1t adds a random noise
to St. This random noise is amplified by the volatility. 8rom the above we can apply simple arbitrage
arguments to get a derivative pricing formula. /y solving the above e5uation we get solution below"
$ S

KS

t!t...............................................................................................(ii)
The above is sometimes called a geometric /rownian motion. The stock price in this model is log:
normally distributed. The 6/:S7 option pricing model is a function of the parameters of the diffusion
process describing the dynamics of the underlying asset price. The no arbitrage principle states that if
options are correctly priced in the market it should not be possible to make a guaranteed profit by
creating portfolios of long and short positions in options and their underlying assets. /y respecting
this principle they derived a theoretical valuation formula for Buropean options on common stocks. 1t
is derived for a geometric /rownian motion with a constant volatility
parameter M. The 6/:S7 formula was initially developed for the shares but the spot e)change rate can
also replace the share price as the underlying asset. The 6/:S7 model for pricing of currency options
has various assumptions which can be summari=ed as"
1 8rictionless arkets :!o ta)es0 transaction costs0 no restrictions on taking long or short
positions0 and no market control.
2 1nterest rates are riskless0 continuously compounded0 and constant.
3 Spot rates change instantaneously and they have a normal distribution
c K SN 6d 7 L Xe
LrT
N 6d 7 .......................................................................... 6iii 7
($ '
p K Xe
LrT
N 6Ld
'
7 L S
(
N 6Ld
$
7 ...................................................................... 6iv 7 ln6
S % X 7 ; 6r ;M
'
%'7T ................................................................6 v7
ln6 S
(
% X 7 ; 6r LM
'
%'7T
d
'
K
?here"
K 4urrent market of underlying asset:Spot B)change rate. CK -ptionHs e)ercise price rK
Risk free rate of interest TK time0 in years0 until the option e)pires
M
K Jolatility 6as
measured by the standard deviation7 of the price of underlying asset. "n K !atural log e K
a mathematical constant number" '.D$9... !K 4umulative area under the normal curve.
8or the /lack:Scholes model0 the only input that is unobservable is the future volatility of the
underlying asset. -ne way to determine this volatility is to select a value that e5uates the theoretical
6/:S7 price of the option to the observed market price. This value is often referred to as the implied or
implicit volatility of the option. *nder the 6/:S7 model implied volatilities from options should be the
same regardless of which option is used to compute the volatility.
27272 Ga%"an an- K('.'a!n "(-!.
3arman and Kohlhagen 6$G9&7 e)tended the /lack Scholes model to cover the foreign e)change
market0 3arman and Kohlhagen suggested that foreign e)change rates could be treated as non:
dividend paying stocks. ?here they allowed for the fact that currency pricing involves two interest
rates and that a currency can trade at a premium or discount forward depending on the interest rate
differential. The 3arman and Kohlhagen formula applies only to Buropean options. 3arman and
Kohlhagen 6$G9&7 e)tended the 6/:S7 to cope with the presence of two interest rates the domestic
interest rate and the foreign currency interest rate.
The model assumed that 1t is easy to convert the domestic currency into the foreign currency and that
we can invest in foreign bonds without any restrictions. The standard 3arman and Kohlhagen foreign
currency option pricing model has the following form"


:


. 6vii)



;


6viii) ?here"




K

6ix)
#

#

(x)
+nd0
4" Theoretical price of a call option
@" Theoretical price of a put option
S" @rice of the underlying currency
K" Strike price
t" Time to e)piration in years M"
+nnual volatility
1 " Risk:free rate in the foreign currency
2 " Risk:free rate in the foreign currency !6

7 and ! 6

7" the cumulative normal distribution
function. This model is similar to the black Scholes model but was adapted to be used in valuation of
currency options and the key difference is that it uses two interest rates the domestic risk free rate and
the foreign currency interest rate.3arman and Kohlhagen 6$G9&7 suggested that foreign e)change
rates could be treated as non:dividend:paying stocks.
27273 B,n(",a. (9#,(n 9%,&,n "(-!.
4o)0 Ross and Rubinstein 6$GDG7 developed the binomial option pricing model that is a discrete time
model which contains the continuous time 6/:S7 model as a special limiting case. Despite its
simplicity0 the model can be applied to Buropean and +merican style options. 8urthermore0 it is
applicable for the valuation of a variety of comple) derivatives.1n the binomial model as indicated by
the name the price of the underlying stock S is assumed to follow a multiplicative binomial process
over discrete time periods. ?e can also say that the stock price follows a
random walk0 because in each period0 it may either move up by a certain percentage amount u:$
where u N $ or down by a certain percentage amount $ :d where d < $. ?e denote the 6physical7
probability of an upward move as
p
and the 6physical7 probability of a downward move as $ :
p
. .et

be the current value of a Buropean style option0 whereas f can be either a call 6
7 or a put 6

7 option. Then

6

or
7 is the optionOs price if the stock price moves upward0 and

6

or

its pri$e if t%e sto$& pri$e moves do'n'ard(
?ith probability p
?ith probability $ :p
1f the call option is only away one period from e)piration0 Then

6

orand

6

or

are given by

K ma) 6

u
:K2 (7 or

K ma) 6K :

u2 (72

K ma) 6

d :K2 (7 or

K ma) 6K :

d2 (72
273
R!4,!; (/ E"9,%,&a. S#*-,!$
8abo==i0 >auser and Aaari 6$GG(7 conducted a research that compared the performance of the /arone
+desi ?haley 6/+:?7 model for currency options and 3arman Kohlhagen model in pricing
+merican currency options. 1t was shown that the 6/+:?7 model is superior to the 3arman
Kohlhagen model in pricing out:of:the:money long:term put options and inferior in pricing in:the:
money short:term put options. The two models performed e5ually well in pricing call options. The
research further shown that the interest rate differential across countries has a greater effect on the
probability of gainful early e)ercise in foreign currency puts than that of calls. The +merican model
identified a large number of opportunities in our sample for gainful early e)ercise among in:the:
money options maturing in less than EF days. These findings suggest the need for a further
investigation of the e):post conse5uences of early e)ercise decisions based on the 6/+:?7 model. 1n
combination with our results0 such an investigation was found to be useful in the developments of
trading strategies and the testing of market efficiency.
4ampa and 4hang 6$GGF0 $GG97 conducted a research to test the suitability of the 6/:S7 model argue
that the 6/:S7 model generates accurate option values even though it may be misspecified0and use 6/:
S7 implied volatilities to forecast e)change rate variance and the correlations between e)change rates.
>amilton and Susmel 6$GGE7 present a regime switching model in which each regime is characteri=ed
by a different +R4> process. 1n their model0 the null of a single regime would be e5uivalent to a
single +R4> process governing innovations. 1n this sense their regime switching model nests a
standard +R4> process. >owever0 as >amilton and Susmel point out0 the general
econometric problem of regime switching models remains" the null of a single regime is not testable
in the usual way since parameters of the other regimes are not identified. >amilton and Susmel rely
on standard linear regression statistics as a simple measure of relative fit.
/ollen et al 6'((&7 compares the performance of three competing option valuation models in the
foreign e)change market0 one based on a regime:switching process for e)change rate changes0 one
based on a 3+R4> process0 and the other based on jump diffusion. Three tests are e)ecuted based on
the parameter values implicit in option prices. The first test compares in sample fit of option prices.
The study found out that 3+R4> model is superior to the regime:switching model for the 3/@0 but
the two models perform about the same for the ,@A. /oth models dominate an ad hoc valuation model
based on /lack Scholes0 but both are dominated by the jump diffusion model. The second test
compares out:of:sample fit of option prices. >ere the 3+R4> model performs better than the
regime:switching model for both e)change rates0 and again both are superior to an ad hoc valuation
model. The jump:diffusion model offers only modest improvement over the others for the 3/@
options. The third test simulates the role of a market maker who sells options and uses the competing
valuation models to hedge the positions. 1n this test0 the 3+R4> and regime:switching models
perform almost identically. +n ad hoc strategy is superior for the 3/@ and is inferior for the ,@A. The
jump:diffusion model performs as well as the ad:hoc strategy for the 3/@ and is superior to all others
for the ,@A options.
Kalivas and Dritsakis 6$GGD7 in their study dealing with volatility forecasting techni5ues and volatility
trading in the case of currency options they sought to provide evidence on how foreign e)change rates
are moving under time varying volatility. They sought to identify the e)istence of
heteroscedasticity then applied widely acclaimed methods in order to estimate future e)change rates
under changing volatility. They then used different methods for estimating future foreign e)change
volatility0 such as implied volatility and historical volatility approaches.1n their study implied and
historical volatility were compared and it was found0 that historical volatility is the best
appro)imation. The white
H
s test for e)istence of heteroscedasticity showed that there was time variation in volatility.
+bken and !andi 6$GG#7 model the volatility in such a way that the future volatility depends on a
constant and a constant proportion of the last periodHs volatility. They used the +R4> framework to
predict volatility.Thus0 +R4> models provide a well:established 5uantitative method for estimating
and updating volatility.
!atenberg 6$GGE7 proposed a forecast by using a weighting method0 giving more distant volatility
data progressively less weight in the forecast. The above weighting characteristic is a method which
many traders and academics use to forecast volatility. 1t depends on identifying the typical
characteristics of volatility0 and then projecting volatility over the forecasting period.
elino and Turnbull 6$GG(7 found that the stochastic volatility model dominates the standard option
valuation models. 1n addition0 they pointed out that a stochastic volatility model yield option prices
which coincide with the observed option prices market prices.They generali=ed the model to allow
stochastic volatility and they report that this approach is successful in e)plaining the prices of
currency options. Though this model has the disadvantage that their models do not
have closed form solutions and re5uire e)tensive use of numerical techni5ues to solve two
dimensional partial differential e5uations.
Scott and Tucker 6$G9G7 e)amined the relative performance of three different weighting schemes for
calculating implied volatility from +merican foreign e)change call options on the /ritish pound0
4anadian dollar0 Deutschemark0 Aen2 and Swiss franc. They found no evidence that one of the three
weighting schemes is superior to the others.
Kroner et al. 6$GGF7 found out implied volatility being higher than historical volatility due to the fact
that if interest rates are stochastic0 then the implied volatility will capture both asset price volatility
and interest rate volatility0 thus skewing implied volatility upwards0 and that if volatility is stochastic
but the option pricing formula is constant0 then this additional source of volatility will be picked up by
the implied volatility.Kroner et al 6$GGF7 also point out that0 since e)pectations of future volatility
play such a critical role in the determination of option prices0 better forecasts of volatility should lead
to a more accurate pricing and should therefore help an option trader to identify over:or underpriced
options. Therefore a profitable trading strategy can be established based on the difference between the
prevailing market implied volatility and the volatility forecast.
Dontwi0 Dedu and /iney 6'($(7in pricing of foreign currency options in a developing financial
arket. They conducted a research seeking to develop a suitable approach to the valuation of foreign
currency options in an underdeveloped financial market in 3hana. Jolatility analysis was done. This
included the application of the 3+R4> model which resulted in the marginal
volatility measure. 8urther0 the pricing of basic foreign currency options in the local market was
obtained from the marginal volatility measure. The research had the following findings and
conclusions" The resulting 3+R4> specification volatility measure can then be implemented as an
input in the pricing of theoretically formed currency options in the local market. This analysis can
form the basis for the pricing of currency options in developing financial the local markets.
1mplementation of the standardi=ed instruments is e)pected to follow the further development of the
domestic 8ore) market0 its si=e0 li5uidity and legislative framework. 1n the beginning the further
@ricing of 8oreign 4urrency -ptions in a Developing 8inancial arket implementation of forward
and swap contracts is appropriate0 until the volume of trading reaches levels That would re5uire
standardi=ation of contracts and their variety. ore comple) pricing schemes would then be available
and ade5uate 8ore) management schemes created. This opens avenue for further research directions.
>eston 6$GG&7 proposed a closed form solution for options with stochastic volatility with applications
to bond and currency options where he used a new techni5ue to derive a closed:form solution for the
price of a Buropean call option on an asset with stochastic volatility. The model allows arbitrary
correlation between volatility and spot asset returns. >e introduced stochastic interest rates and shows
how to apply the model to bond options and foreign currency options. Simulations show that
correlation between volatility and the spot assetHs price is important for e)plaining return skewness
and strike:price biases in the /lack Scholes 6$GD&7 model. The solution techni5ue is based on
characteristic functions and can be applied to other problems.
4hen and 3au 6'((E7 investigates the relative pricing performance between constant volatility and
stochastic volatility pricing models0 based on a comprehensive sample of options on four currencies0
including the /ritish pound0 Deutsche mark0 ,apanese yen and Swiss franc0 traded fre5uently in the
@hiladelphia Stock B)change 6@>.C7 from $GGE to '(($. The results show that >eston model
outperforms the 63:S7 model in terms of sum of s5uared pricing errors for all currency options and
the adjustment speed toward the long:run mean volatility in the currency market is faster than that in
the stock market.
@osedel 6'((#7 analy=ed the implications of volatility that changes over time for option pricing. The
nonlinear:in:mean asymmetric 3+R4> model that reflects asymmetry in the distribution of returns
and the correlation between returns and variance is recommended. >e used the !3+R4> model for
the pricing of foreign currency options. @ossible prices for such options having different strikes and
maturities are then determined using onte 4arlo simulations. The improvement provided by the
!3+R4> model is that the option price is a function of the risk premium embedded in the
underlying asset. This contrasts with the standard preference:free option pricing result that is obtained
in the /lack:Scholes model.
+loo 6'($$7in his e)ploratory study of currency options in the Kenyan financial market with a
specific focus on the use or lack of use of currency options in the Kenyan financial market. The study
found that currency markets did e)ist in Kenya but only to a limited e)tent as only E.$I of
respondents said that the commercial banks they worked for offered currency options as one of their
treasury products. Twenty three percent of respondents attributed the slow growth of a currency
options market to low risk appetite by Kenyan commercial banks. There e)isted
demand from clients to support the growth of a currency option market as F#I of the respondents
said they had received in5uiries for currency options.
+kinyi 6'((D7 did a study where she compared the classical /:S model and the 3arch option pricing
model in Kenya and she looked at the conse5uences of introducing heteroscedasticity in option
pricing. The analysis showed that introducing heteroscedasticity results in a better fitting of the
empirical distribution of foreign e)change rates than in the /rownian model. 1n the /lack:Scholes
world the assumption is that the variance is constant0 which is definitely not the case when looking at
financial time series data. The study priced a Buropean call option under a 3arch model 8ramework
using the .ocally Risk !eutral Jaluation Relationship. -ption prices for different spot prices are
calculated using simulations. The study used the non:linear in mean 3arch model in analy=ing the
Kenyan foreign e)change market.
27: C(n&.*$,(n /%(" .,#!%a#*%! %!4,!;
The original option pricing model was developed by /lack and Scholes 6$GD&7. Since then0 it has
been e)tended to apply to foreign currency options in 3arman and Kohlhagen0 $G9&2 3rabbe0 6$G9#7.
3arman and Kohlhagen 6$G9&7 suggested that foreign e)change rates could be treated as non:
dividend:paying stocks. 8rom the initial studies of foreign currency option valuation various
assumptions were made by /lack and Scholes 6$GD&7 and research from that time has been focused of
rela)ing some of the assumptions. 8rom the literature volatility is the main variable involved where
by most researchers now focus on developing a model of predicting future volatility based on either
historical data or implied volatility.
Jolatility forecasts have many practical applications such as use in the analysis of market timing
decisions0 aid with portfolio selection and the provision of estimates of variance for use in option
pricing models. Thus0 it follows that it is important to distinguish between various models in order to
find the model which provides the most accurate forecast the literature provides conflicting evidence
about the superiority of each method. -ne the one hand0 some researchers stress that relatively
comple) forecasts 6+R4>7 and 63+R4>7 models and implied volatility forecasts provide estimations
with the best 5uality. 8rom the literature review we can conclude that most of the models of option
pricing are based on the initial model of /lack and Scholes and almost all the models start there and
go on and rela) some of the unrealistic assumptions made by the black Scholes model of option
pricing. 1n general we can say that /lack P Scholes assumed that the financial market is a system that
is in e5uilibrium. ost research on pricing of currency options have concentrated in developed
markets and there is a research gap to conduct research in valuation of developing and emerging
markets like the Kenya market. The financial markets of developed countries where most of the
research on the valuation of foreign currency options has been carried out is different from the
financial market in Kenya in terms of efficiency and the way they are structured .+lso there is
currently no market for trading of options in Kenya and some data used in the model is not readily
available as in the developed financial markets. Due to the above differences in the financial markets
in developed economies and Kenya
H
s financial market there is need to come up with a model that properly fits the available data in Kenya
hence the model developed specifically for Kenya will give more accurate results in valuation of
foreign currency options in Kenya compared to using the already developed models for developed
countries.
CHAPTER THRE
E
RESEARCH METHODOLOGY
371 In#%(-*&#,(n
This chapter discusses the type of research methodology used in the study. 8irst the research design
used is discussed and itHs very important to select the appropriate research design as this will enable
you to achieve the research objectives. The population of the study is then defined and the sample that
will be used is then selected and justified. Data collection methods and data analysis methods that will
be used are then discussed. Then the conceptual and empirical models are then defined and various
variables defined and then finally the data validity and reliability is e)plained.
372 R!$!a%&' -!$,n
Research design refers to how data collection and analysis are structured in order to meet the research
objectives through empirical evidence economically Schindler 6'((#7. This research uses descriptive
research design which is a scientific method which involves observing and describing the behavior of
a subject without influencing it in any way. The research looks at *SD%KS>S e)change rate in the
past and analyses it to come up with a pricing model for foreign currency options in Kenya.
373 P(9*.a#,(n
4ooper and Bmory 6$GGF7 define population as the total collection of elements about which the
researcher wishes to make inferences. The population of interest in this study is the foreign currency
e)change rates in Kenya.
37:
Sa"9.!
The sample for this research will be the daily *SD%KS>S e)change rate for F years from '((9 to
'($'.The e)change rates used in formulating the model for predicting volatility are the mean daily
e)change rates from ,anuary '((9 to December '($' with $'F& daily data e)change rates for the
*SD against the KS>S. The e)change rate for the *SD against the Kenya Shilling range from a low
of #$.F$ in ay '((9 to a high of $(F.G$ in -ctober '($$ but the majority of the e)change rates lie
between D(:G( against the *SD. 8or the simulation of the foreign currency option pricing e)change
rate data for ,anuary '($& is used. The *SD is used for itHs the most traded currency and most
transactions in Kenya are pegged against the *SD which also acts as the intermediary in triangular
currency transactions. The e)change rates are given by appendi) &.
37= Da#a C(..!&#,(n
This study will use secondary data for the various variables that will be put into the model. The
secondary data will be obtained from 4entral bank of Kenya and Kenya bureau of statistics. The
secondary data collected will cover a period of five years from '((9 to '($'.
376 Da#a Ana.5$,$
This study will use both descriptive and inferential statistics to analy=e the data. +nalysis will be done
using the Statistical package for social scientists 6S@SS Jersion '(7.Secondary data will be collected
then regression analysis will be carried out to model the volatility e5uation and the gained volatility
estimate used in the valuation of foreign currency options.
37>
C(n&!9#*a. "(-!.
This study will use 3+R4> 6$0 $7 which estimates current volatility as a function of the long:run
average variance0 a single lagged s5uared return and a single lagged variance.The model is based is
based on the original propositions of /lack and Scholes model as adjusted by the 3arman Kohl
>agen odel. *nder this model the foreign currency call 647 and put 6@7 option is a function of the
following si) variables below 4%@K f 6S0 K0 T0

M7.
?here" 6S7 is the current currency spot rate06K7 the strike price06T7 the time to e)piration06

7 the local
risk free interest rate0 06

7 the foreign risk free interest rate and6 M7 is the volatility.
37? E"9,%,&a. "(-!.
+ standard 3+R4> 6$0 $7 model is used to estimate the volatility of the foreign currency option.
3+R4> is an approach to estimating conditional volatility. 3+R4> 6$0 $7 estimates current volatility
as a function of the long:run average variance0 a single lagged s5uared return and a single lagged
variance.
B

C

DDDDDDDDDDDDDDDDDDDDDDDDDD77 6xi)
?here"
1s the conditional variance of the return at time t.
" The s5uared random component of the return in the previous period0
The previous period historical variance.
+nd

K

)%e ana*ysis entai*s t%e +tting of t%e ,-./0 112 13 spe$i+$ation for t%e 14S0S3 and 15S63 e7$%ange rate and t%e imp*ementation of
t%e gained vo*ati*ity measure in t%e pri$ing of foreign
$urren$y options in t%e 4enyan mar&et. 8n$e t%e varian$e is estimated standard deviation '%i$% represents t%e vo*ati*ity is attained
9y +nding t%e s:uare root of t%e varian$e. )%e vo*ati*ity is estimated on mont%*y 9asis and is assumed to 9e $onstant over t%at
mont%. )%e a9ove vo*ati*ity mode* is used to predi$t vo*ati*ity for t%e ne7t period '%i$% is t%e mont% t%at fo**o's .)%e vo*ati*ity 'i** 9e
predi$ted 9y t%e a9ove mode* t%en t%e resu*tant vo*ati*ity p*ugged into t%e ,arman and 4o%*%agen mode* stipu*ated 9e*o'. -** t%e
varia9*es 9e*o' are o9serva9*e e7$ept vo*ati*ity '%i$% 'i** 9e estimated from t%e a9ove mode*.



:


(vii)



;


6viii) ?here"



K
#

.. 6xi7

#. ..6x) +nd0
4" theoretical price of a call option
@" theoretical price of a put option
S" price of the underlying currency
K" strike price:6Simulated values are used7.
t" time to e)piration in years
M" annual volatility
1 " The risk:free rate in the foreign currency
2 The risk:free rate in the Kenya economy.
!6

7 and ! 6

7" the cumulative normal distribution function +ll the above variables are observable e)cept annual
volatility which will be estimated by the 3arch 6$0 $7 model above and the foreign currency call and
put options will be valued at various simulated strike prices.
37@ Da#a Va.,-,#5 A R!.,a+,.,#5
The data validity and reliability will be assured for this study will use secondary data from trusted
sources of 4entral bank of Kenya and the Kenya national bureau of statistics.
CHAPTER FOU
R
DATA ANALYSIS AND PRESENTATION
:71 In#%(-*&#,(n
This of data analysis and presentations has two major parts. 8irst the data is clearly presented and
defined0 data analysis methods used for the research is also discussed and finally summary and
findings are clearly interpreted.
:72 Da#a P%!$!n#a#,(n
:7271 Va%,an&!
The variance is a measure of the s5uared deviations of the observations from the mean. 1n this
research first price relatives are calculated from the e)change rates given0 then natural logs of the
price relatives are now used as the variable by which the variance is estimated. 1n this research
variance is assumed to follow an historical trend where the variance of todayHs period determines the
variance of the following periods. The variance in this research is a function of two main dependent
variable whereby current periodHs variance depends on previous period variance and previous period
s5uared log returns. The variance used in the study is the historical variance which is calculated based
on the returns of the *SD%KS>S e)change rates and the variance period is thirty days.
:7272 S0*a%!- .( R!#*%n$
S5uared log returns is one of the independent variable is this research. 8or this research s5uared log
returns for the e)change rates is used to estimate variance and conse5uently the volatility. The
s5uared log returns has been determined to be a goon variable for estimating the variance
from previous studies done in this area of pricing of foreign currency options. To determine the
s5uared log returns first the e)change price relative rates is calculated and the price relative relates the
current daily e)change rate with the previous dayOs e)change rate and it
H
scomputed by dividing current daily e)change rate by the previous day e)change rate. The s5uared
log returns is based on the natural logarithm of price relative of the *SD%KS>S e)change rates as
illustrated in appendi) $.
:7273 R,$8 /%!! %a#!
Risk free interest rate is the theoretical rate of return of an investment with =ero risk including the
default risk. The risk free rate represents the interest that an investor would e)pect from an absolutely
risk free investment over a given period of time.Risk free rate can be said to be the rate of interest
with no risk. Therefore any rational investor will reject all the investments yielding sub risk free
returns.The risk free rate is usually obtained from government securities which offer a guaranteed
return with no risk. The risk free rates used are the &#E days Treasury bill rate for the domestic Kenya
interest rate which in ,anuary '($& averaged $$.#DI and the foreign risk free rate the $ year Treasury
bill for *S+ was used in the study and the foreign risk free rate is as shown in appendi) '.
:727: S#%,8! 9%,&!
The strike price is defined as the price at which the holder of currency options can buy in the case of a
call option or sell in the case of a put option the underlying security when the option is e)ercised.
Since we donHt have the options market in Kenya the foreign currency options was priced based on
simulated strike prices of D(09(0G( and $((.These four strike prices are ade5uate in this analysis as
they help portray various pricing dynamics of foreign currency options
pricing.The strike prices selected will be ade5uate in illustrating the pricing of foreign currency
options the e)change rate for the *SD versus the Kenya shilling is usually within this range.
:727= T,"! #( "a#*%,#5
The time to maturity is the period that remaining before the option e)pires. This research assumes that
the currency options are Buropean currency options that can only be e)ercised on the maturity date on
their e)piry date. The time to maturity used in this study is a foreign currency option of # months and
this translates to a (.F fraction of a year.
:7276 V(.a#,.,#5
Jolatility is one of the major variable in this research and coming up with a good volatility estimate is
very key in coming up with an ade5uate and accurate foreign currency pricing model. Jolatilityshows
the variation in data in relation to the mean. 1f the data is close together0 the standard deviation will be
small. 1f the data is spread out0 the standard deviation will be large. Jolatility is estimated from a
sample of recent continuously compounded returns .This research uses historical volatility estimates
and assumes that volatility of the past will hold in the future and in this research variance from past
data of the e)change rates for the *SD against the Kenya shilling is calculated and a regression model
based on the 3arch 6$0 $7 framework is formulated to predict future volatility. 8rom the predicted
variance estimates we obtain the standard deviation by finding the s5uare:root of the estimated
variance which represents the volatility used in pricing of foreign currency options. The volatility used
in this study is as predicted by the variance model and itHs shown in appendi) '
:73
R!%!$$,(n %!$*.#$ ana.5$,$ an- a99.,&a#,(n (/ "(-!.7
Regression analysis was conducted for the above model and produced the following results
summari=ed below.
odelR R
S5uare
+djusted
R S5uare
Std. Brror of the
Bstimate
$ .GGFa .GG( .GG(
.
(((((FD#F'FE$
'$
Ta+.! 1:M(-!. S*""a%5
@redictors" 0 0

Dependent Jariable"

R s5uare is the coefficient of determination and shows by what proportion the variations of the
dependent variable are e)plained by the independent variables. 8rom above the R S5uare statistic
gives the goodness of fit of the model which shows how good the regression model appro)imates the
real data points. +n R s5uare of $.( indicates that the regression line perfectly fits the data. The R
s5uare of this model is .GG( which shows that the model is a good fit of the actual data. 4oefficient of
correlation ranges between :$ to $ and in this model the coefficient of correlation is .GGF which shows
a high positive correlation between current period variance0 previous period variance and previous
period log returns.
Ta+.! 2:C(!//,&,!n#$
odel 4oefficients T Sig.
/
Std.
Brror
E.$F&B:
((D .G#9 .
($'
.((( .
((& .
(('
'.$&G
&'$.E$
( #.F9G
.(&& .((( .
(((
Dependent Jariable"

1ndependent variable"0
8rom above the analysis of the data a variance model can be fitted for the e)change rate data of *SD
against Kenya Shilling. 8rom the coefficients obtained above we have the following variance model
which satisfies the 3arch 6$0 $7 conditions as 1C2 E17
B 07000000:1=3C07@6?

C07012

The above model is the model that is used to predict variance then we find the s5uare root of the
estimated variance to get the standard deviation which will be used as the volatility in the 3arman
Kohlhagen model as illustrated below.
/y use of simulation for a hypothetical foreign currency call and put option can be valued as shown
below. Since strike price data is not available valuation of the currency option can be valued under for
strike prices of D(0 9(0 G( and $(( e)change rates for the *SD. ,anuary '($& *SD%KS>S e)change
rates are used to generate the variables inputted in the variance model which is used to estimate
volatility for the period of ,anuary ':$F.
Ta+.! 3: S#%,8! 9%,&! a# >07
K=70
Date:
,anuary
'($&
B)chang
e Rate
6S7
MI
&#E day T:
/ill :4/K
T
4all
@rice
@ut
price
' 9#.(D#G
$.D&&G
FF9G9
$$.#DI
$F
I
(.
F
$&.9'E
G('&#
G.'F'D
B:F#
& 9#.&F#G
$.D&FE
GG9'9
$$.#DI
$F
I
(.
F
$E.(9E
#D(F&
$.D9$9
&B:FD
E 9#.EE$D
'.$&9#
#$G(D
$$.#DI
$F
I
(.
F
$E.$#&
&E&$9
&.#E$G
$B:&G
D 9#.E'#E
'.$FD$
DFG#&
$$.#DI
$F
I
(.
F
$E.$EG
$E9D
$.DD9G
DB:&9
9 9#.EDDF
'.$#$$
&('''
$$.#DI
$E
I
(.
F
$E.FG9
D(F#'
'.(E&'
$B:E(
G 9#.F'E'
'.$#(9
#G(DE
$$.#DI
$&
I
(.
F
$F.(E#
#&$#D
$.FF#&
GB:E'
$( 9#.#(F&
'.$F99
&E(&
$$.#DI
$E
I
(.
F
$E.D$D
9#FFF
E.D($D
&B:E$
8irst for the analysis of the model in practice first we look at the foreign currency option having a
strike price of D(.The strike price of D( is below the spot e)change rates which are above 9# for the
simulation period of ,anuary '($& and hence its advantageous for the currency call holders to e)ercise
the calls as they would gain while for put holders they would lose out hence no put holder would
e)ercise their put currency options. 8or this reason based on the laws of demand and supply and
practical options trading we have a higher demand for currency call options hence the higher price
compared to the currency put options. The price of the currency call option ranges between $&.9':
$F.(E while the currency put option prices for this period of simulation are statistically Qero as shown
in the above table.
Ta+.! :: S#%,8! 9%,&! a# ?07
KB?0
Date:
,anuary
'($&
B)chang
e Rate
6S7
MI
&#E day T:
/ill :4/K
T
4all
@rice
@ut
price
' 9#.(D#G
$.D&&G
FF9G9
(.$$#D
(.
'
(.
F
E.&G$D
(FEF#
&.DD(#
FB:(D
& 9#.&F#G
$.D&FE
GG9'9
(.$$#D
(.
'
(.
F
E.#F$E
D&&FE
G.GFE'
'B:(9
E 9#.EE$D
'.$&9#
#$G(D
(.$$#D
(.
'
(.
F
E.D&($
F&FG'
D.#9GG
9B:(#
D 9#.E'#E
'.$FD$
DFG#&
(.$$#D
(.
'
(.
F
E.D$FG
#(GE
G.F$&'
GB:(#
9 9#.EDDF
'.$#$$
&('''
(.$$#D
(.
$
(.
F
F.$#FF
$($GF
$.9F&9
FB:(#
G 9#.F'E'
'.$#(9
#G(DE
(.$$#D
(.
$
(.
F
F.#$&E
&ED(9
&.$'9D
#B:(D
$( 9#.#(F&
'.$F99
(.$$#D
(. (. F.'9E#$.$E$B
!ow looking at the option prices at strike price of 9( where the strike price of 9( is below the spot
e)change rates which are above 9# for the simulation period of ,anuary '($& and hence its
advantageous for the currency call holders to e)ercise the calls as they would gain while for put
holders they would lose out hence no put holder would e)ercise their put currency options. 8or this
reason based on the laws of demand and supply and practical options trading we have a higher
demand for currency call options hence the higher price compared to the currency put options. The
price of the currency call option ranges between E.&G:F.#$ while the currency put option prices for
this period of simulation are statistically Qero as shown in the above table. 8rom above we can see
that the call prices are lower that for the strike price of D( and this is for the reason that the strike
price of 9( is closer to the spot e)change rate than that of D(.
Ta+.! =: S#%,8! 9%,&! a# @07
KB@0
Date:
,anuary
'($&
B)chang
e Rate
6S7
MI
&#E day T:
/ill :4/K
T
4all
@rice
@ut
price
' 9#.(D#G
$.D&&G
FFG
$$.#DI
$F
I
(.
F
F.#(&G
$B:(9
F.(E$E
G''FF
& 9#.&F#G
$.D&FE
GG9&
$$.#DI
$F
I
(.
F
$&.''$
(G&DF
E.D9$D
'E'F'
E 9#.EE$D
'.$&9#
#$G$
$$.#DI
$F
I
(.
F
'.E'DF
#B:(F
E.D(&(
DF#F$
D 9#.E'#E
'.$FD$
DFG#
$$.#DI
$F
I
(.
F
'.#D$9
'B:(F
E.D$D'
D'F#G
9 9#.EDDF
'.$#$$
&(''
$$.#DI
$E
I
(.
F
(.((($
'(D(F
E.'#D9
(G#E'
G 9#.F'E'
'.$#(9
#G(D
$$.#DI
$&
I
(.
F
(.(((E
#'9G$
&.9'('
'FDDE
$( 9#.#(F&
'.$F99
$$.#DI
$E (. (.((($ E.$E9D
!ow looking at the option prices at strike price of G( where the strike price of G( is now above the
spot e)change rates which are above 9# for the simulation period of ,anuary '($& and hence its
advantageous for the currency put holders to e)ercise the puts as they would gain for they can buy the
currency from the foreign currency market at a lower e)change rate of 9# and then sell it at G( hence
gaining from e)ercising their put options. while for call holders they would lose out by e)ercising the
currency call options as they will be buying the currency at G( and can only sell the currency to the
market at only 9# hence no call holder would e)ercise their call currency options. 8or this reason
based on the laws of demand and supply and practical options trading we have a higher demand for
currency put options hence the higher price compared to the currency call options. The price of the
currency put option ranges between &.9':F.(E while the currency call option prices for this period of
simulation are statistically Qero as shown in the above table.
Ta+.! 6: S#%,8! 9%,&! a# 1007
KB100
Date:
,anuary
'($&
B)change
Rate 6S7
MI
&#E day T:
/ill :4/K
T
4all
@rice
@ut
price
' 9#.(D#G
$.D&&G
FF9G9
$$.#DI $FI(.F
$.9DE$
&B:E&
$E.E
DED
& 9#.&F#G
$.D&FE
GG9'9
$$.#DI $FI(.F
9.(9EE
GB:E'
$E.'
$EG
E 9#.EE$D
'.$&9#
#$G(D
$$.#DI $FI(.F
E.$D&G
'B:'9
$E.$
&#'
D 9#.E'#E
'.$FD$
DFG#&
$$.#DI $FI(.F
$.($(9
9B:'D
$E.$
F(E
9 9#.EDDF
'.$#$$
&('''
$$.#DI $EI(.F
#.$F('
#B:'#
$&.D
((G
G 9#.F'E'
'.$#(9
#G(DE
$$.#DI $&I(.F
'.F&'(
DB:'E
$&.'
F&
$( 9#.#(F&
'.$F99
&E(&
$$.#DI $EI(.F
$.F(&$
$B:'F
$&.F
9$D
!ow finally looking at the option prices at strike price of $(( where the strike price of $(( is now
above the spot e)change rates which are above 9# for the simulation period of ,anuary '($& and
hence its advantageous for the currency put holders to e)ercise the puts as they would gain for they
can buy the currency from the foreign currency market at a lower e)change rate of 9# and then sell it
at $(( hence gaining from e)ercising their put options. while for call holders they would lose out by
e)ercising the currency call options as they will be buying the currency at $(( and can only sell the
currency to the market at only 9# hence no call holder would e)ercise their call currency options. 8or
this reason based on the laws of demand and supply and practical options trading we have a higher
demand for currency put options hence the higher price compared to the currency call options. The
price of the currency put option ranges between $&.'F:$E.ED while the currency call option prices for
this period of simulation are statistically Qero as shown in the above table. 8rom above we can see
that the currency put prices are higher for the strike price of $(( compared to that of G( and this is due
to the fact that at strike price of $(( is further away from the spot e)change rates of 9# hence you will
be gaining more when you e)ercise the put currency options hence the higher price.
:7:
S*""a%5 an- In#!%9%!#a#,(n (/ F,n-,n$
The research used a two:step approach in pricing of foreign currency options in Kenya by first
developing a model for predicting volatility and then plugging the predicted volatility estimates into
the 3arman Kohlhagen model to obtain the price of the foreign currency options in Kenya. The
research used regression analysis and the 3arch 6$0 $7 model to formulate a model for predicting
variance. The predicted variance estimates are then converted into volatility estimates that are in turn
used in valuation of foreign currency options. The 3arch 6$0 $7 model obtained yields an appropriate
model which has a high coefficient of determination of (.GG( and this implies that the 3arch 6$0 $7 is
a good model for fitting volatility using the *SD%KS>S daily e)change rate data. The model also
satisfies 3arch 6$0 $7 condition for the coefficients in the model 6; 0.987 <$and this shows that the
model is a good fit for actual data.The selected independent variables of the previous day s5uared log
returns and previous dayHs variance determine to a large e)tent current dayHs variance estimates.
8rom the above simulated foreign currency option prices as shown in tables &:# where we have strike
prices of D(09(0G( and $(( the foreign currency call price is higher than the currency put price which
is almost statistically =ero when the strike price is below the daily spot e)change rates for the strike
prices of D( and 9(. This is due to the fact that when the strike is below the spot e)change rate
e)ercising the currency call options a holder of the currency call option would gain as he can buy the
currency at the lower strike price and sell it in the market at the higher e)change rate. ?hile for the
foreign currency put option holders they would lose out if they e)ercised the puts for they would have
to sell the currency at a lower price than that that they can freely obtain from the foreign e)change
market.
?hen the strike price is above the daily spot e)change rate as shown in tables F and # the foreign
currency options the foreign currency put price is higher than the currency call price which is almost
statistically =ero when the strike price is above the daily spot e)change rates for strike prices of G(
and $((. This is due to the fact that when the strike is above the spot e)change rate e)ercising the
currency put options a holder of the currency put option would gain as he can buy the currency at the
lower spot e)change rate and sell it at the higher spot e)change rate. ?hile for the foreign currency
call option holders they would lose out if they e)ercised the calls for they would have to pay more
than the market spot e)change rate for the currencyand hence they would not e)ercise them.
8rom above simulation as shown in tables &0 E0 F and # using ,anuary '($& *SD%KS>S e)change rate
data foreign currency options can be valued in Kenya and the results obtained show that the valuation
is consistent with previous literature and studies done on the valuation of foreign currency options
especially the studies that used the 3+R4> pricing like inDontwi0 Dedu and /iney 6'($(7in pricing
of foreign currency options in a developing financial arket in 3hana. The e)change rates between
,anuary ':$F range between 9#.(D#G:9#.#9F& and using the strike prices of D(0 9(0 G( and $(( this
study yields results consistent with previous theories and literature. 8rom theory and previous studies
done in the area of currency options valuation for call options0 the higher the strike price0 the cheaper
the currency call option and for put option the lower the strike price the cheaper the currency put
option. This model results also shows that the 3arch 6$0$7 also yields a good model for estimating the
variance and the volatility used in pricing of foreign currency options.
CHAPTER FIV
E
SUMMARY3 CONCLUSIONS AND RECOMMENDATIONS
=71 S*""a%5
The main objective of this study was to show how foreign currency options can be valued in Kenya
under stochastic volatility and also to come up with a model for predicting variance and volatility of
e)change rates. This research used descriptive research design which is a scientific method which
involves observing and describing the behavior of a subject without influencing it in any way. The
research looked at *SD%KS>S e)change rate in the past and analyses it to come up with a pricing
model for foreign currency options in Kenya. The research looked at various literatures on valuation
of foreign currency options identifying the major models used. The research sought to show how
currency options can be valued in Kenya under stochastic volatility.
The study used 3arman Kohlhagen model for valuation of foreign currency options whereby two
interest rates of domestic and foreign risk free rate. The study used 3arch 6$0 $7 model to fit the
variance regression line which was used to predict variance and subse5uently the volatility that is
plugged into the 3arman Kohlhagen model. The research had various findings that were consistent
with previous research done in the area of valuation of currency options. The research found out that
for call options when the spot e)change rate is below the strike price the option has statistically =ero
value and when above strike price the option has a positive value. -n the other hand the price of a put
currency option is positive when the spot e)change rate is below the strike price and statistically =ero
when the spot e)change rates are above the strike prices and the further away from the strike price the
spot e)change rate is the higher the value of the option.
=72
C(n&.*$,(n$
8rom the findings various conclusions can be drawn. 8irst from the findings the 3arch 6$0 $7 model
used for predicting variance used for predicting the volatility used in valuation of foreign currency
yields an appropriate model which has a high coefficient of determination of (.GG( and this implies
that the 3arch 6$0$ 7 is a good model for fitting volatility using the *SD%KS>S e)change rate data.
The model also satisfies 3arch 6$0 $7 condition for the coefficients in the model 6; 0.987 <$and this
shows that the model is a good fit for actual data
8rom the study another conclusion is that the prices of currency call and put option obtained from the
model are consistent with historical literature and empirical studies in the area of foreign currency
options valuation. 8rom the research findings we can conclude that if the spot e)change rate is below
or above the strike price of the foreign currency determines to a great e)tent thee price of the foreign
currency option.
?hen the spot e)change rate is below the currency option strike price the price of the currency call
option is statistically =ero and the price of the currency put option is positive as a holder of the put
option would gain from e)ercising them hence high demand and price subse5uently. -n the other
hand when the spot e)change rate is above the strike price the price of the currency put option is
statistically =ero and the price of the currency call option is positive as the holders of the currency
options would gain by e)ercising the call options and hence high demand and price of the currency
call options. >ence the further the spot e)change rate is from the strike price the higher the price of
the foreign currency calls and put option.
=73
P(.,&5 R!&(""!n-a#,(n$
8or introduction of currency options in Kenya the first policy recommendation is to formulate a good
and robust regulation framework. *nder this the 4entral bank of Kenya should formulate an ade5uate
regulatory framework for introduction of derivative trading in Kenya. The regulatory framework
should give definitions of the various derivative instruments like swaps0 calls0 puts and clearly spell
out the procedures that will be followed when trading in the derivatives trading. 8or currency options
the regulatory framework should indicate the minimum trade of the currency options allowable0
clearly spell out conditions that you need to fulfill in order to be allowed to trade in the currency
options for the dealers.
The 4entral /ank of Kenya and the 4apital markets authority should also spearhead faster
introduction of an options market in Kenya where options and other derivatives and futures can be
traded. The options market will be very important as it will provide increased li5uidity in the financial
market. The options market will also be another source of capital and it will be very essential in
management of risks associated with various underlying assets like foreign e)change rates which are
volatile. The options market will also enhance stability of importers and e)porters cash flows and this
will in turn lead to a more stable economy.
The 4entral bank of Kenya should adopt measures to improve market efficiency especially in the
foreign e)change market whereby stable macroeconomic policies should be adopted and the foreign
e)change market left to operate more freely devoid of interference. B)change rates should be
determined by market forces of demand and supply and be more liberali=ed and with the increased
efficiency in the foreign e)change market this will lead to better and more accurate models of
valuation of foreign currency options in Kenya.
=7:
L,",#a#,(n$ (/ #'! S#*-5
?hen conducting this various limitations were encountered. The first limitation was the lack of an
options market in Kenya and this is the main limitation to this study for one to ascertain how good the
model is in valuation of foreign currency options you need to compare the price obtained from the
model and the prices that are in the options market. The prices given by model should of valuation of
foreign currency options should be consistent with the prices of the same options in the actual options
market for foreign currency options.
+nother limitation is the lack of high levels of efficiency in the foreign e)change market especially
informational efficiency and the foreign e)change market in Kenya is subject to interference through
various macroeconomic policies and the market is even subject to political interference. This
interference inhibits the foreign e)change market which affects foreign e)change rates which in turn
affects the 5uality of the model obtained.
+nother limitation of the study is the assumptions in the study of no ta)es and no transaction costs
some of which are not realistic. This has an impact for in todayHs financial markets ta)es are in all
financial transactions and transaction costs are in all financial dealings as the financial intermediaries
usually charge a commission and in this study we assume no transaction costs which in reality is not
possible in reality of todayHs financial markets.
+nother limitation of this study is that some variables used do not e)ist like the strike prices where
valuation of the foreign currency options have to be valued by simulation of prices of the foreign
currency options at various strike price of D(0 9(0 G( and $((.
=7=
S*!$#,(n$ /(% F*%#'!% S#*-,!$
8urther studies relating to this study can be done in the following areas. 8irst valuation of currency
options under constant volatility using /lack Scholes model can be conducted and here volatility
would be constant and not vary as in this study and the resulting valuation of currency options can be
compared with the values of the foreign currency options obtained in this study.
The volatility risk premium embedded in currency options whereby volatility risk premium can be
analy=ed for over the counter currency options. >ere we analy=e if volatility has a term structure
which volatility risk premium decreases towards maturity of the option. >ere we look at volatility and
how volatility varies in the life of the currency option up to the maturity date of the currency option.
>edging with foreign currency options is another area where additional studies can be conducted and
here one can look at how you can use the currency options to hedge against foreign currency risk.
>ere one will be able to come up with hedging strategies0 whether to purchase a call or a put and the
volume to purchase.
+nother area that further studies can be conducted is the pricing of currency Swap. 4urrency swap is
the best way to fully hedge a loan transaction as the terms can be structured to e)actly mirror the
underlying loan. 1t is also fle)ible in that it can be structured to fully hedge a fi)ed rate loan with a
combined currency and interest rate hedge via a fi)ed:floating cross currency swap. The currency
swaps will be an additional tool for hedging against financial risk.
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GD9:$('&.
APPENDICES
Dat
e
B)change Rate:
ean Rate
M MI
$ :
' 9#.(D#G
#.$#B:
(D
&.GFB
:(D
(.((((
($$G
(.($D&
&GF#
$.D&&GFF
G(
& 9#.&F#G
&.$FB:
(D
&.G#B
:(D
(.((((
($'(
(.($D&
FF((
$.D&FEGG
9&
E 9#.EE$D
$.(FED
$B:(F
D.$$B
:(D
(.((((
($9'
(.('$&
9##'
'.$&9##$
G$
F :
# :
D 9#.E'#E
G.#&&'
'B:(D
D.'DB
:(D
(.((((
($9F
(.('$F
D$D#
'.$FD$DF
G#
9 9#.EDDF
&.$&&&
9B:(9
D.&$B
:(D
(.((((
($9F
(.('$#
$$&(
'.$#$$&(
''
G 9#.F'E'
&.EG&D
FB:(D
D.&(B
:(D
(.((((
($9F
(.('$#
(9#G
'.$#(9#G
(D
$( 9#.#(F&
'.G$E#
GB:(D
D.'GB
:(D
(.((((
($9F
(.('$F
99&E
'.$F99&E
(&
$$ 9#.#D''
9.DDD'
DB:(D
D.E(B
:(D
(.((((
($9D
(.('$D
$G'G
'.$D$G'G
(9
$' :
$& :
$E 9#.#9EE
F.G#'E
GB:(D
D.&#B
:(D
(.((((
($9#
(.('$#
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