Abstract:
Financial derivatives offer a great investment opportunity when accurately priced.
Developing countries such as Kenya are yet to establish the mechanisms of trading
in derivatives. This research seeks to demonstrate how advances in developed money
markets can be reflected towards the establishment of derivatives markets in developing
countries. To achieve this, the dynamics of the inter bank offered interest rates
in developing markets and developed markets are compared. The two interbank offered
rates are found to be similar under an appropriate martingale measure. A
European caplet for the developed money market is priced using the local volatility
interbank offered rate model. The accuracy of the local volatility interbank offered
rate is found to be better when benchmarked against the industry accepted Black’s
model. The local volatility model is used as it captures the volatility smiles more
efficiently in one sweep.
