International Journal of Business and Social Science Vol. 2 No. 7; [Special Issue –April 2011] 289 Modelling Volatility of Short-term Interest Rates in Kenya Tobias Olweny Department of Commerce and Economics, JKUAT-Kenya Email: toolweny@yahoo.com 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 behavior of interest rates which is tested 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 modeling 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). Keywords: Volatility, interest rate, Kenya 1.1. Background to the Study Traditional theories define interest rate as the price of savings determined by demand and supply of loanable funds. It is the rate at which savings are equal to investment assuming the existence of a capital market. The loanable fund theory argues that interest rate is determined by non-monetary factors. It assigns no role to quantity of money or level of income on savings, or to institutional factors such as commercial banks and the government. The liquidity theory, on the other hand, looks at the interest rate as the token paid for abstinence and inconveniences experienced for having to part with an asset whose liquidity is very high. It is a price that equilibrates the desire to hold wealth in the form of cash with the available quantity of cash, and not a reward of savings. Interest rate is a function of income. Its primary role is to help mobilize financial resources and ensure the efficient utilization of resources in the promotion of economic growth and development (Ngugi and Kabubo, 1998). Short-term interest rates are charges levied by the lenders to the borrowers on loans that must be paid within a year such as Treasury bills and credit card loans. The Short Term Interest Rates are important variables in many different areas of the economic and financial theory. They are important in many financial economic models, such as models on the term structure of interest rates, bond pricing models and derivative security pricing models. They are also important in the development of tools for effective risk management and in many empirical studies analyzing term premiums and yield curves where risk free short-term rates are taken as reference rate for other interest rates. Besides, they are also a crucial feature of the monetary transmission mechanism. Duguay (1994) describes the monetary transmission mechanism as starting with a monetary authority’s actions influencing short-term rates and the exchange rate, which then go on to ultimately affect aggregate demand of inflation. In order to understand the characteristics of the monetary transmission mechanism, it is therefore imperative to have a good model of the behaviour of short-term interest rates. Empirical evidence documents a level effect in the volatility of short term rates of interest (Olan and Sandy, 2005; Turan and Liuren, 2005). That is, volatility is positively correlated with the level of the short term interest rate. Using Monte-Carlo simulations, Olan and Sandy (2005) examined the performance of the Engle- Ng (1993) tests which differentiate the effect of good and bad news on the predictability of future short rate volatility. The short-term interest rates being the US three month Treasury bills rates taken from the Federal Reserve Bank of St. Louis Economic database were sampled at a weekly frequency over the period of 5 th January 1965 to 4 th November 2003 yielding 2027 observations.