Design and valuation of Kenya shilling currency options

Abstract

Foreign exchange rates have become a source of concern for most manufacturers and the business community as a whole. Since Kenya maintains a flexible exchange rate, the value of the kenya shilling is determined by the market forces of supply and demand. Thus any events that could potentially harm the country's stability or are percieved by the international markets as having an effect on the local economy,have a direct impact on the value of the shilling and may cause its value to fluctuate. Since events affecting the value of any currency can not always be predicted accurately, movements in the foreign currency markets often leave substantial amounts of loss in their wake. If a manufacturer has to import raw materials then a depreciation in the local currency would result in higher production costs as more units of the local currency would be required to purchase a unit of the foreign currency. It would therefore cost more to impport goods. On the other hand if the local currency appreciates against major world currencies then exporters would have to accept a cut in their profit margins since their products would not be competitively priced owing to high production costs locally as a result of strong local currency. "\ This paper aims to design .a financial instrument that would be used by firms to hedge against foreign exohjrage exposure. . , The currency values and trade volume data that will be used in this paper are for the year ending 2007 as compiled by the central bank of kenya. ' Given that Kenya's balance of trade up to the year ending 2007 was negative; this imp;ies that the country imported more than it exported.The major currencies used in terms of trading volume were the US Dollar, the Euro and the British Pond Sterling. This paper will structure and price currency derivatives with the shilling against these three major currencies.