AN EXPLORATORY STUDY OF CURRENCY OPTIONS IN THE KENYAN

FINANCIAL MARKET

BY

ROBERT M ALOO

UNITED STATES INTERNATIONAL UNIVERSITY

NAIROBI
SPRING 2011

ii
 AN EXPLORATORY STUDY OF CURRENCY OPTIONS IN THE KENYAN
FINANCIAL MARKET

BY

ROBERT M. ALOO

A Project Report Submitted to the School of Business in Partial Fulfillment of the

Requirement for the Degree of Masters in International Business Administration (MBA)

UNITED STATES INTERNATIONAL UNIVERSITY

NAIROBI
 SPRING 2011
STUDENT’S DECLARATION

I, the undersigned, declare that this is my original work and has not been submitted to any
other college, institution or university other than the United States International
University in Nairobi for academic credit.

Signed: Date:

Robert Morris Aloo (ID 621842)

This project has been presented for examination with my approval as the appointed
supervisor.

Signed: Date:

Mr. Francis Mambo Gatumo

Signed: Date:

Dean, School of Business

Signed: Date:

Deputy Vice Chancellor, Academic Affairs

iv
v
 COPYRIGHT

Copyright © 2009 Robert Morris Aloo. All texts, graphics or other works are copyrighted
works of Robert Morris Aloo. All rights reserved. No part of this report may be recorded
or otherwise reproduced or transmitted in any form or by electronic or mechanical means
without prior permission or authority granted by the author.

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 ABSTRACT

This study looked at currency options, with a specific focus on the use or lack of use of
currency options in the Kenyan financial market. Currency options according to the
Reuters financial glossary (Reuters, 2007) defines options as an instrument that gives the
holder the right but not the obligation to buy or sell an underlying financial asset.
Currency options can serve the economic hedging function by transferring risk of an
unfavorable move in exchange rate from the option buyer to the option seller. The option
buyer is therefore able to lock in a price for exchange of currency in the future and
transfer risk to the option seller who is compensated by the premium paid. Currency
options if properly understood in the Kenyan economy can serve as a tool to deepen the
financial markets.

The purpose of the study was to explore currency options, how they are utilized and who
they can benefit in the Kenyan market. The study was conducted during the first nine
months of 2009. The study sought to answer the following questions; firstly, If currency
options exist in the Kenyan financial markets, secondly, why don’t commercial banks
offer currency options in Kenya and finally, if the existence of currency options if at all
would thrive in the Kenya financial markets.

The study was descriptive in nature, explaining and elaborating on the various types of
options, applications and benefits to users. It reviewed currency options and how they are
used to hedge against currency fluctuations. The review concentrated on the theoretical
framework surrounding currency options.

To achieve the aims of the study, a survey of currency dealers in commercial banks in
Kenya was undertaken. The survey was in the form of a questionnaire that targeted the
market participants according to a list sourced from the Central Bank of Kenya. A sample
size of forty-two commercial banks was identified where two dealers from each
commercial bank were randomly sampled. The pre-tested semi structured questionnaires
were administered to a total of 84 respondents in the sampled population by means of e-
mail. The views collected were collated and summarized using percentages, ratios, means
and frequencies.

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The study found that currency markets did exist in Kenya but only to a limited extent as
only 4.1% 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 existed demand from clients to support the growth of a currency
option market as 56% of the respondents said they had received inquiries for currency
options. The study further found that a majority of the respondents (81%) thought the
Central Bank of Kenya and the Capital Markets Authority had a major role in the growth
of currency options. Furthermore, a majority of the dealers sampled had knowledge on
currency options with slightly over 68% stating that they had adequate knowledge.
Legislation was found to be a factor impeding the development of a currency option
market. The study noted that to increase access to currency options, increased product
knowledge by clients and bank personnel was necessary. Finally, respondents thought
that the currency options market would thrive in Kenya if there was extensive training
covering areas around accounting procedures for options, risk management awareness
and the advantages of using currency options as hedging techniques for currency
fluctuations.

The study concluded that there was little room for currency options to be traded in an
over the counter market in Kenya. The study however noted that with clients becoming
more and more knowledgeable about opportunities for hedging their currency exposures,
increased demand by clients would see a push towards a more active currency options
market. The research showed that the currency options market would be useful to
business people in Kenya and its growth would be a welcome development in the
financial market.

The study recommends education for both business people and financial sector personnel
on the advantages of currency options. The study also recommends that market players
should engage the regulators in order to provide some regulatory framework for currency
options. It also recommends that risk management by bank staff and regulatory
authorities be strengthened. The study recommends that market players market currency
options to clients. Finally the study recommends that players should encourage the
growth of an active foreign exchange market that could improve access to more
sophisticated products.

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 ACKNOWLEDGMENT

I would like to acknowledge Leonard Aloo and Theresa Aloo for giving me useful
suggestions on this project. I acknowledge the support from my family over the period of
this course. I give thanks to my supervisor who guided me through this project. I lastly
thank God for his sacred hand over my journey in life thus far.

ix
 DEDICATION

To Lydia Nafula, and Obura Aloo siblings, who stood by me, supported me and loved
me.

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 TABLE OF CONTENTS

STUDENT’S DECLARATION..........................................................................................iv
...................................................................................................................................v
COPYRIGHT......................................................................................................................vi
ABSTRACTvii
ACKNOWLEDGMENT.....................................................................................................ix
DEDICATION.....................................................................................................................x
TABLE OF CONTENTS....................................................................................................xi
LIST OF TABLES.............................................................................................................xii
LIST OF FIGURES..........................................................................................................xiii
CHAPTER 1.........................................................................................................................1
1.0 INTRODUCTION..........................................................................................................1
1.1 Background of the Study................................................................................................1
1.2 Statement of the Problem...............................................................................................4
1.3 Purpose of the Study .....................................................................................................5
1.4 Research Questions .......................................................................................................5
1.5 Importance of the Study.................................................................................................5
1.6 Scope of the Study..........................................................................................................6
1.7 Definition of Terms........................................................................................................7
1.8 Chapter Summary ........................................................................................................11
CHAPTER 2.......................................................................................................................12
2.0 LITERATURE REVIEW.............................................................................................13
2.1 Introduction..................................................................................................................13
2.2 Do Currency Options exist in Kenya?..........................................................................13
2.3 Do commercial banks provide currency options in Kenya?.........................................17
2.4 Would currency options thrive in Kenya?....................................................................24
2.5 Chapter Summary.........................................................................................................33
CHAPTER 3.......................................................................................................................33
3.0 RESEARCH METHODOLOGY.................................................................................34
3.1 Introduction..................................................................................................................34
3.2 Research Design...........................................................................................................34
3.3 Population and Sampling Design ................................................................................35
3.4 Data Collection Methods..............................................................................................36
3.5 Research Procedures....................................................................................................37
3.6 Data Analysis...............................................................................................................38
3.7 Chapter Summary.........................................................................................................38
CHAPTER 4.......................................................................................................................39
4.0 RESULTS AND FINDINGS.......................................................................................39
4.1 Introduction to Data Analysis .....................................................................................39
4.2 General Information.....................................................................................................39
4.3 Do Currency Options exist in Kenya? .........................................................................41

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4.4 Why don’t commercial banks provide currency options in Kenya?............................45
4.5 Would the currency options market thrive in Kenya?..................................................50
4.6 Chapter summary.........................................................................................................50
CHAPTER 5.......................................................................................................................52
5.0 DISCUSSION, CONCLUSIONS AND RECOMMENDATIONS.............................52
5.1 Introduction..................................................................................................................52
Summary............................................................................................................................52
5.3 Discussion....................................................................................................................53
REFERENCES...................................................................................................................60
Appendix D. E-mail questionnaire.....................................................................................65
Appendix E. Banks to whom questionnaires were administered.......................................68
Appendix F. Graph of Kenya Shilling VS US Dollar.......................................................71

LIST OF TABLES

Table 1: Derivatives and the Underlying Assets................................................................14

Table 2 South Africa trading volume of over the counter derivatives...............................31
Table 3 Sample size distribution........................................................................................36
Table 4 Percentage of derivatives provided by banks in Kenya........................................44
Table 5 Hindrances to the growth of over the counter options market in Kenya ..............45
Table 6 Benefits of using currency options by clients.......................................................46

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 LIST OF FIGURES

Figure 1: Long Call McCafferty (2007)..........................................................................21

Figure 2: Short Call McCafferty (2007)..........................................................................21
Figure 3: Long Put McCafferty (2007)...........................................................................22
Figure 4: Short Put McCafferty (2007),...........................................................................22
Figure 5: Straddle McCafferty (2007)..............................................................................23
Figure 6: Strangle McCafferty (2007)..............................................................................24
Figure 7: Global Financial Crisis and Cost of Bailouts.....................................................29
Figure 8: Segmentation of respondents by type of bank...................................................40
Figure 9: Length of service by treasury personnel...........................................................40
Figure 10: Ranking of knowledge as a percentage of respondents....................................41
Figure 11: The role knowledge plays in provision of currency options .......................42

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Figure 12: Inquiries received from clients........................................................................43
Figure 13: Sectors of the economy that demand options..................................................44
Figure 14: Customers knowledge of currency options.......................................................47
Figure 15: Role of CBK and CMA in provision of currency options................................48
Figure 16: Areas requiring development by CMA and CBK.............................................49
Figure 17: Factors hindering provision of currency options .............................................49

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 CHAPTER 1

1.0 INTRODUCTION

1.1 Background of the Study

Basic options are encountered on a daily basis in everyday life. For example, when you
cut out a coupon in a newspaper or magazine, that allows you to buy a product in a shop
at a discounted price, this is a form of an option. If you plan to purchase the goods, you
will purchase the newspaper at a fee. You will then cut out the coupon and take it to the
store where you can acquire the goods at a discount. Without the coupon, you do not have
an option to purchase the commodity at a discount (Reuters, 2007). There is also the case
where you may be looking to purchase a house in Nairobi; many buildings are purchased
at plan level. This gives the person who puts down the deposit on the house an option to
purchase the home at a price fixed early on during construction. This is a form of an
option as the person who puts up the deposit need not buy the house and can even sell the
right to another person before the building is complete. The examples above are options
that we use in our everyday lives.

An option is “a financial instrument that gives the buyer or holder the right, but not the
obligation, to buy or sell an underlying financial asset or commodity”. Unlike futures,
where the buyer has to fulfill the contract, an option gives one a choice to exercise or not.
An option contract specifies a future date on or before which it can be exercised. This
date is known as the expiry date. Options are flexible instruments that allow investors to
benefit from favorable price movements while limiting the consequence of unfavorable
price movements (Taylor, 1997). Options holders have to pay a premium for the
protection just as with insurance contracts. There are two types of options, a call, which
gives the holder the right to buy the underlying instrument, at a set exercise price; and a
put, which gives the holder the right to sell the underlying instrument at a set strike price.
Two or more options transactions can be combined to create a spread. These strategies
usually involve the simultaneous purchase and sale of options with different prices or
expiry dates, within the same class. American style options can be exercised at any time
before the expiry date, whereas European style options can be exercised only on specific
expiry dates and not before the prescribed date (Reuters, 2003).

1
Currency options are part of the formal financial markets, which constitute today’s
integrated financial systems that link people, regions and countries into an active
mechanism that spurs economic growth by use of production, trade and finance. Currency
options are a development of the foreign exchange process that has resulted from the
constant change and development in the financial markets. These options can be
purchased to hedge a transaction from the effects of currency movements. The currency
option is 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 (Chance et al, 2008).

Taylor (1997) explains that currencies have been with us for a long time and we have
used them for many years. The use of currencies has been mentioned in such historical
books as the Bible, in which we are informed of moneychangers and moneylenders who
sat outside the temple in Jerusalem over 2000 years ago. The two currencies used for
trade were the Israeli shekel and the Roman dinar. Moneychangers set the exchange rate
as the Romans collected taxes from the Jews whose domestic currency was the shekel that
was converted to the Roman dinar. The services offered by moneychangers were one
form of financial intermediation, to facilitate trade.

The existence of financial intermediaries is related to the theory of the firm. We view
banks and other financial intermediaries as a special kind of firm. Savings and surpluses
are collected within the bank and latter supplied to firms with deficits. Firms with needs
go to intermediation banks, through which they are able to get loans and other funding
sources like overdrafts and asset financing. The existence of intermediaries allows
households with surplus funds to lend to firms through intermediation. Banks therefore
provide unique services in financial intermediation that are not available through other
lenders like the capital markets (Winton et. al, 2002).

The appreciation of the role of banks in the savings and investment process and corporate
finance has contributed to the rapid growth of our economies. The financial institutions
that carry out intermediation can be characterized as firms that borrow from one group of
agents and lend to another group of agents that require funds. Within this functioning
process, there arose the need to provide other products especially as the intermediaries
expanded. With the advent of international trade, these intermediaries have come up with

2
new and innovative ways to support the processes within the organizations. This involves
the development of products like currency options and forward contracts that assist the
intermediary and the agents in carrying out transactions that increase the levels of comfort
in a given financial undertaking in the foreign exchange markets (Winton et. al, 2002).

Currency options have therefore developed to solve the problem surrounding issues of
imperfect information during decision-making related to foreign exchange transactions,
where an exchange rate is required. An everyday businessperson does not have the luxury
of perfect information; the businessperson may have to make an order to purchase some
goods with shipment of the goods coming many moths latter. The trader will however be
required to make payment once the goods are shipped, hence the trader will make use of
the available information at the time of making the order to arrive at suitable estimates on
the future rate of exchange. These estimates may require significant adjustments when the
time of actual payment arrives. Making a significant variance between the budgeted and
actual payment amounts on a transaction is known as an exchange rate risk (Winton et. al,
2002).

Currency options have developed as solutions to issues that relate to foreign currency
payments. An option does not come at zero cost like a forward contract but is immensely
flexible, and some options can be designed to have a very low or even zero premium
(Taylor 1997). An option therefore provides businesses with flexibility in payments and
allows for the exit from a contract without full performance and payment of the
underlying sums. The flexibility of the currency option is the main attraction to
businesses. The currency option will ensure one is not in a long-term contract as the
premium paid is the only cost if one does not want to take up the contract. Options are
therefore simple tools that hedge one's currency exposure by ensuring the buyer of the
contract derives maximum benefits from positive movements but is able to utilize the
option in case of adverse movements. The providers of currency options are mainly
commercial banks and established exchanges such as the London International Futures
and Options Exchange.

The Kenya shilling has tended to oscillate in wide bands, which leads both importers and
exporters to search for ways of protecting themselves. For example, in December 2007
the Kenya shilling had appreciated to touch highs of 60.50 just prior to Kenya’s elections.

3
However, in the subsequent four months to April 2008 the Kenya shilling depreciated
rapidly to touch lows of 74.00 shillings to the dollar. The events of Kenya’s post election
violence and subsequent uncertainty caused a sharp depreciation in the shilling that
caught many importers by surprise. In a reverse occurrence, the Kenya shilling had
appreciated significantly immediately before the election period. With the country full of
optimism, the shilling gained significant ground from about 67.00 Kenya shillings to the
dollar in October and November 2008 to the highs of 60.50 just before the general
election in the month of December 2007. Such currency movements may occur in less
dramatic scales during normal periods, but importers and exporters require taking
precautions in order to safeguard their earnings. Currency options are ways that their
revenues can be protected. A chart of the movements of the currency within the period is
attached in Appendix 4.0 (Reuters, 2007).

Companies can protect themselves against the effects of volatile currency markets by
hedging through currency options, among other instruments. It is important that Kenyan
regulators, companies and financial providers appreciate the use of currency options; this
is because currency options are required by importers and exporters to facilitate global
trade, as the word becomes a global village.

1.2 Statement of the Problem

Currency options have arisen from the adoption of a floating exchange rate regime in
many countries, which has promoted the rapid globalization of national economies and
attempts by multinationals to seek investment opportunities and markets beyond their
immediate borders (Salifu, 2004). Studies in Kenya have focused on price and exchange
rate dynamics, monetary and exchange rate policy and price determination and the role of
exchange rates and monetary policy in managing payments (Ndungu’u, 1999).

Currency options have not been studied and remain an enigma in Kenya. This study
therefore sought to fill the existing research gap and add to the body of knowledge on
currency options and exchange rate management; it explains the challenges of currency
options from a Kenyan perspective and the hindrance of the development of active
currency options markets. The study looked at the advantages of using currency options

4
and their limitations, the conditions for establishing over the counter currency options
and the capacity of commercial banks to trade in currency options.

1.3 Purpose of the Study

The purpose of the study was to determine the extent and degree of utilization of currency
options in the Kenyan foreign exchange market, and to suggest ways to remove
hindrances to the growth of the currency option market.

1.4 Research Questions

The study sought to answer the following question:
1.4.1 Do currency options exist in Kenya?
1.4.2 Why don’t commercial banks offer currency options in Kenya?
1.4.3 Would the existence of currency options thrive in Kenya?

1.5 Importance of the Study

1.5.1 Kenyan Financial System
The study provides information on trading in currency options in the Kenyan financial
system. This information should be valuable to regulators such as the Central Bank of
Kenya, currency options players such as banks, dealers in currency options and their
clients. The study shows which hedging options are in use. It also provides useful data on
the Kenyan currency market and its development.

1.5.2 Financial Experts

The study contributes to the understanding of the use and application of currency options
in Kenya. The bottlenecks that hinder the penetration and use of currency options will
form an important source of data to regulators who would want to improve the trading of
currency options. The study is a base for future studies of options and their application in
Kenya.

1.5.3 Government and Stakeholders

Government and many non-governmental organizations are often involved in transactions
that are paid for at a future date. In an environment where there are currency fluctuations,

5
there is a need for highly leveraged investments. The premium paid out to purchase an
option is only a fraction of what would be needed to purchase outright the underlying
asset, therefore magnifying one’s profits if the move is correct (McCaffery, 2007). This
form of investment provides users with a flexible form of insurance against movements in
currency. It is important to understand the global growth and usage of options and
compare them with the local setting. This should prove useful to investors in Kenya who
may include companies, government bodies, non- governmental organizations, pension
funds, and fund managers.

1.5.4 Scholars
The study adds to the limited literature available on currency options in Kenya. This will
provide a vital starting point for other studies that will look into options and derivatives in
general in Kenya.

1.6 Scope of the Study

This study focuses on currency options. It strives to develop an understanding of currency
options in the Kenyan market. The study reviews ways the Kenyan market can be
improved and hindrances in the trading of currency options removed. It seeks to improve
the understanding of over the counter currency options. To do so we have interviewed
bank treasury dealers in forty-two commercial banks in order to provide accurate
information. Treasury dealers are financial experts who are engaged in the daily provision
of foreign currency solutions to bank clients. The information provided by currency
dealers gives us an indicator of developments in the currency market.

The study limits its scope to the Kenyan financial sector, and only looked at currently
traded or available financial instruments. The study covered commercial banks based in
Nairobi (Kenya’s capital city), and specifically targeted treasury-dealing rooms as the
areas of survey to generate information about the Kenyan market. The study has limited
itself to bank treasury dealers. This group of professionals interacts daily with both
importers and exporters, and is knowledgeable about the instruments used to hedge
various foreign exchange transactions.

6
1.7 Definition of Terms
1.7.1 At the money (A.T.M)
An option is described as being at the money when the exercise price is approximately
the same as the underlying price (Demark et al, 1999).

1.7.2 Bank of International Settlements (BIS)

BIS is an organization that promotes international monetary and financial co-operation
and serves as a bank for central banks and international financial organizations. It accepts
deposits from central banks and makes short-term loans to them. The BIS is concerned
with the stability of the global financial system and ensuring banks have sufficient funds
to support their operations (Demark et al, 1999). The Basel committee of the BIS sets
standards and guidelines for best banking practice.

1.7.5 Currency dealers

They are individuals or institutions that trade financial instruments and take positions for
their own account in various currencies. This involves buying one currency, which leads
to a corresponding sell in the counter currency (Reuters financial glossary, 2003).

1.7.6 Currency Risk

Currency risk is the potential losses arising from adverse moves in exchange rates. The
risk of these adverse movements arises from the probability that an investment in a
particular currency will make a loss or realize unexpected returns. The currency risk can
be measured (Demark et al, 1999).

1.7.7 Exchange rate

An exchange rate is defined as the price of one currency that can be exchanged for a unit
of another currency (Fabozzi et al 1998). The use of foreign exchange arises because
different nations have different monetary units and the currency of one country needs
conversion in order to make payments in another country. Because of trade, travel, and
other transactions between individuals and business enterprises of different countries, it
becomes necessary to convert money into the currency of other countries in order to pay
for goods or services in those countries.

7
1.7.8 Exchange traded instrument
Exchange traded instruments are standard currency contracts traded on a recognized
exchange and are the opposite of the over the counter instrument (Demark et al, 1999).
Some of the instruments that can be exchange traded are stocks, commodities, currencies
and derivatives like options and futures.

1.7.9 Exercise
This is conversion of the option into the underlying physical transaction or cash
settlement. This would mean that the holder of the options has decided to utilize the
option. At this stage, the writer of the option is mandated to deliver to the holder on the
agreed terms of the option (Demark et al, 1999).

1.7.10 Expiry date

Is the date on which a European option can be exercised. Unlike American options that
can be exercised on any date during the term of the contract, a European option has a
fixed date on which it can be exercised or utilized (Demark et al, 1999).

1.7.11 Floating Exchange Rates

A floating exchange rates system is an arrangement in which currencies have no fixed
parities and exchange rates. Prices are determined by supply and demand in the free
market. A country’s currency strengthens or weakens based on the underlying strength of
the economy and its relationship with its trading partners. An oversupply of currency can
damage exports by making its goods too expensive for other countries to buy. A weak
currency makes its exports cheaper to buy and its imports more expensive. A sudden
weakening of a currency can indicate economic instability (Reuters financial glossary,
2003).

1.7.12 Foreign exchange markets

Foreign exchange markets also known as Forex markets, are markets that deal in the
exchange of deposits in different currencies for varying dates. Transactions are generally
for twelve months or less and are in the form of spot, forwards, futures or options.
Foreign exchange rates refer to the number of units of one currency one needs to buy
another (Chance et al, 2008).
1.7.13 Forward contract

8
Forward contracts are agreements to buy or sell a commodity or a financial asset at a
specified future date for a fixed price. It is a completed contract and the commodity or
financial asset will be delivered (Chance et al, 2008).

1.7.14 Intrinsic value

The intrinsic value is the difference between the strike price of the option and the market
price of the underlying asset. This comparison indicates whether the option is considered
in-the-money, at-the-money, or out-of-the-money. An option is in-the-money if it has
intrinsic value and out of the money if it does not have intrinsic value (Demark et al,
1999).

1.7.15 In the money (I.T.M.)

An option is described as being in the money when the current price of the underlying
instrument is above the strike or exercise price for a call, and below the strike price for a
put (Demark et al, 1999).

1.7.16 Leverage
This is the measure of the amount of money spent purchasing an option, compared to the
actual value of the underlying position. The more highly leveraged the trading position,
the greater the risk that a small change in market price will completely wipe out the cash
investment (Demark et al, 1999). It also shows that a small change in market prices in the
right direction can produce large profits in relation to the size of the cash investment.

1.7.17 Leveraged transactions

Leveraged transactions are the use of debt to magnify an investments return or credit
facilities. For example, one can purchase an asset by borrowing funds, with the asset used
as collateral for the borrowing. The buyer then uses the assets cash flow to repay the loan
or sell it in smaller units to finance the loan (Chance et al, 2008).

1.7.18 London International Financial Futures and Options Exchange

9
The London International Financial Futures and Options Exchange also known as LIFFE,
this is an exchange based in London that trades in futures and options contracts on
currencies, bonds, equities and commodities (Chance et al, 2008).

1.7.19 Open position

An open position is a position that has not yet been closed or offset. The holder has a
future commitment to buy or sell something which has not yet been fulfilled, or of which
there is no matching contract in the opposite direction (Reuters financial glossary, 2003).

1.7.20 Over the counter instrument (O.T.C instrument)

An over the counter instrument is a market conducted directly between dealers and
principals via a communication mode (Chance et al, 2008). Unlike an exchange, there is
no automatic disclosure of the price of deals to other market participants, and the deals
are traded in a non-standardized form.

1.7.21 Out of the Money (O.T.M)

An option is described as being out of the money when the current price of the underlying
Instrument is below the strike or exercise price for a call (an option buy), and above the
strike for a put (an option to sell) (Chance et al, 2008).

1.7.22 Premium
The option premium = the intrinsic value + time value (Demark et al, 1999). The option
premium is made of the intrinsic value that is the difference between the strike price of
the option and the open market price of the underlying asset plus the time value that is the
component of an option premium that takes into consideration the time to expiry and the
volatility of the underlying instrument (Chance et al, 2008).

1.7.23 Spot transaction

The settlement of a currency transaction two days from the day the deal is agreed
(Reuters financial glossary, 2003). A spot market is defined as a market whose trades are
delivered and settlements are made in two working days after the trade. The markets can
comprise currencies, securities, stocks, precious metals, or commodities.

1.7.24 Strike price

10
The strike price is a price agreed in an option transaction and at which the option may be
exercised. Prices can be described as At-the-money (ATM), In the money (ITM), Out-of-
the-money (OTM) (Demark et al, 1999).

1.7.25 Time value

The time value is the component of an option premium, which takes into consideration
the time to expiry and the volatility of the underlying instrument (Reuters financial
glossary, 2003).

1.7.26 Volatility
Volatility describes the degree to which a value, such as that of interest rate or exchange
rate, changes over a specified period in time. High volatility means that the value changes
dramatically, usually because of uncertainty in the market. Dealers thrive on market
volatility as this means value changes and hence opportunities to make profits (Demark et
al, 1999).

1.8 Chapter Summary

This chapter introduces the study whose main purpose is to determine the extent to which
currency options are used in the Kenyan market. It gives two additional objectives one of
which is to determine hindrances to the use of currency options while the second is to
determine what improvements can be made to the Kenyan financial system to improve
the trade of currency options. Among the beneficiaries of the study are import and export
businesses, commercial banks and regulators of the financial markets. The chapter ends
by giving a definition of some terminologies used in the study. The next chapter shall
focus on literature review.

The study is further organized into chapter’s two to five. Chapter two introduces the
literature around currency options, with a focus on explaining the importance of currency
options in the global financial systems plus usage of currency options in various
developed and developing nations around the world. The literature review drills down to
the application of options to transactions and usage to hedge various commercial
transactions.

11
Chapter three introduces the research methodology used in this study by expounding on
the research design, Population and Sampling design, data collection methods used in the
study, the research procedures applied at various stages of the study and lastly the data
analysis used to reduce the collected data into interpretable findings.

Chapters four and five look at the results of the study and the discussions, conclusions
and recommendations respectively. These chapters try to answer the research questions
from the data collected while endeavoring to provide the way forward in terms of
recommendations to the study. The study does not answer all questions around currency
options and thus candidly point to areas where other scholars can build upon in order to
increase the pool of knowledge around derivatives and more specifically currency options
in the Kenyan financial system.

CHAPTER 2

12
2.0 LITERATURE REVIEW

2.1 Introduction
This chapter reviews literature on currency options, the application and relevance to the
Kenyan market. The chapter starts by looking at options in the global perspective; it
explains how they are traded, their availability and growth of this market in relation to
other financial markets. The review of various payoffs and combinations of currency
options is provided together with a discussion on straddles and strangles. This chapter
reviews the developments in various emerging market countries to give a vision to the
study. We provide a detailed review of currency options and risks associated with their
pricing and use. Finally, the chapter reviews statutes, which cover usage of currency
options by banks in Kenya.

2.2 Do Currency Options exist in Kenya?

The daily volume of traditional foreign currency transactions in 2006 averaged US dollars
1.9 trillion. At the same time the derivatives market daily foreign exchange and interest,
related products turnover averaged US dollars 2.4 trillion (Bank of International
Settlements Survey, 2007). The figures quoted are extremely large showing the
importance of understanding derivative markets. The growth of the derivatives market has
also surpassed that of the traditional foreign exchange products in the market.

Over the counter (OTC) currency and interest related options account for the largest share
of traded derivatives. It is projected that over the counter (OTC) currency options shall
continue to be successful as business needs continue to expand with more banks and
corporate clients seeking to hedge out exposures with derivative products as compared to
traditional spot and forward transactions (Taylor, 1997). Hull (1995) explains that
currency options markets exhibit similar trends in growth to those of foreign exchange
markets, with currency options growth exceeding the underlying because of the leveraged
nature of the product. The underlying asset on a currency option is the forward foreign
exchange rate, while other derivatives like futures have their underlying asset as forward
interest rates; the same applies to all other derivatives that have their own underlying
assets.

13
Table 1: Derivatives and the Underlying Assets
Derivative Underlying
Currency options Forward Foreign exchange rates
Interest rate swaps Government bonds
Interest rate futures Implied forward interest rates

The table above illustrates the types of derivatives traded in developed markets and the
related underlying assets. The underlying assets can be a plain vanilla product such as the
spot foreign exchange or a derivative of another derivative like an option having the
underlying asset as a forward exchange contract.

Currency options are financial instruments that allow the owner the right but not the
obligation, to acquire or to sell a predetermined number of shares or stock, a specific
amount of currency against another currency at a fixed price on or before a specified date.
The option holder has the following three choices available: exercise the option and
obtain a position in the underlying asset; trade the option in the market closing out the
position by an offsetting trade or let the option expire if the contract lacks value at
expiration, losing out on the premium paid (Demark et al, 1999).

In currency markets, the holder of the option (buyer) has all the rights upon payment of
the premium. In contrast, the bank that sells (writer) the option and receives the premium
has obligations and no rights at all under the option. All that is due to, the receipt by the
bank of the premium that contractually provides it with obligations to perform. The bank
must have the underlying foreign exchange in case the holder requires it or rather
exercises his option. In addition, the bank must hedge the risks on the option position.
The underlying is the receipt or payment of one currency against another.

Demark et al (1999), stated that options are more difficult to understand because unlike
trading in the underlying asset in this case the actual currency because options trading is
not as simple as just buying or selling the contract. Rather, there are two types of options,
call options and put options, and each has two sides. One can buy or sell a call option, and
buy or sell a put option, or a combination of them. It is important to note that holding or
selling either a call or put option is completely different. For every call buyer there is a

14
call seller; while for every put buyer there is a put seller. It is important to note that option
buyers have rights, while option sellers have obligations. For this reason, option buyers
have a known level of risk while option sellers have unlimited risk in the contract.

2.2.1 Buying protective call options

By buying a call option, the investor gets into a standard contract that gives the buyer the
right, but not the obligation to buy a predetermined amount of currency against another at
the options strike price, or exercise price, during the contract or at maturity depending on
the nature of the contract. In effect, buying a call option is similar to buying the
underlying or staying long on the underlying currency. One could purchase a call option
contract if one believed that the market price of dollars in this case was going to increase
or appreciate at some point before the date of option expiry. The most the buyer of the
option could lose by purchasing a call option is the price they pay for the option
(premium). They can however make an unlimited amount if the currency moves
indefinitely in their favour. On the other hand, the most the bank that sell the option can
lose is an unlimited amount. This is because the bank has an obligation to sell the amount
bought by the option buyer in the call option, if the contract is exercised, whatever the
prevailing price of the underlying. The most the option seller can make is limited to the
consideration of the contract (premium) (Chance et al, 2008).

2.2.2 Buying protective put options

By buying, a put option an investor gets into a contract that gives the buyer the right, but
not the obligation to sell a predetermined amount of currency against another at the
options strike price, or exercise price, during the contract or at maturity depending on the
nature of the contract. A put option is similar to short selling a currency in the underlying
(or selling dollar against shilling). One could purchase a put option contract if one
believed that the market price of dollars in this case was going to decline or depreciate at
some point before the date of option expiry. The most the buyer of the option could lose
by purchasing a put option is the price they pay for the option (premium) they can
however make an unlimited amount if the currency moves indefinitely in their favour. On
the other hand, the most the banks that sell the option can lose is an unlimited amount.
This is because the banks have an obligation to buy the amount sold by the option buyer
in the put option if the contract is exercised whatever the prevailing price of the
underlying. The most the option seller can make is limited to the consideration of the

15
contract (premium). Options can be transacted in various ways and, with over the counter
options, they can also be tailor made to come up with very flexible options (Chance et al,
2008).

Below are some types of option contracts:

American options can be exercised at any time during the life of the contract, up to and
including the expiry date. According to Demark et al (1999), these options are the most
common since they provide the buyer the extra flexibility of exercising it at any point
during the life of the option.

European options can only be exercised at the end of their lives. The options can be
traded (bought or sold) to third parties during the option life but can only be exercised at
the end of their life or at the maturity date (Demark et al, 1999).

Asian options are those which the payoff is determined by the average value of the
underlying asset during a certain period rather than in terms of the final value. For
example, to exercise the Asian option the average value of the Kenya shilling has to have
traded above 70.00 shillings for a three-week period in the final part of the option’s life
for it to be exercised (Hull 1997).

In Kenya, studies have previously been undertaken around the area of currency options
with some success. Alaro (1998) studied the conditions necessary for the existence of a
currency options market in Kenya. His study analyzed the conditions necessary for the
operation of currency options by reviewing of available literature. Alaro (1998)
concluded that the main conditions for an options market to exist were a growing
economy, supported by the Central Bank of Kenya, a fairly independent exchange rate
mechanism, market liquidity and efficiency, a regulatory organization and a strong and
developing banking system.

The study pointed to the growing demand for options in the Kenyan market. This was
propelled by the increased uncertainty that resulted from the liberalization of the Kenyan
market to allow for a free-floating currency. Because of these developments during the
late 1990’s, companies looked to benefit through hedging using options to reduce the
uncertainty posed by the freely moving exchange rates in Kenya. The study

16
recommended the strengthening of the regulatory framework to provide clear guidelines
as to the operation of currency option markets (Alaro, 1998).

Studies in Kenya have also pointed towards the use and importance of options as a
hedging tool for businesses engaged in foreign exchange transactions. Ochong, (2002)
focused on treasury management in commercial organizations in Kenya. He wanted to
understand how treasuries in Kenya are managed and what tools are employed in this
management. He therefore took a sample of quoted companies on the Nairobi stock
exchange, to find out which tools were utilized in the management of their foreign
exchange exposures, by use of a questionnaire.

The findings of the research pointed to the increased uses of options in Kenya as a
hedging tool to manage currency risk. The study also indicated that today treasury
departments have evolved to focus on much more than just working capital requirements
of the organization but are expected to hedge transactions with the most appropriate tools
in the market. The findings in Ochong’s paper that options were in use in the Kenyan
market by corporate companies supported the need for further study in this area.

Thuku (2000) studied forex bureaus in Kenya. The study looked at how efficiently forex
bureaus use the information at hand. The study sampled forex bureaus in Nairobi in a
similar manner to the one adopted by this study. Thuku sampled specific forex bureaus in
Nairobi to draw conclusions as to their efficiency in the use of financial information. The
studies sample size was restricted to ten forex bureaus from a population of 36 due to
limitations in time and resources. His study concluded that there were some informational
gaps in the functions of Forex bureaus, which required to be addressed. He recommended
the increased use of information technology to address this weakness in the functioning of
Forex bureaus in Kenya.

2.3 Do commercial banks provide currency options in Kenya?

Alaro (1998) found that the currency options market existed but it was not as complex as
other markets in the world. However, the same principles apply, for example Yehia
(1999), studied the infant currency market in Israel with a view to determining whether
the currency option market was efficient. The study appreciated the infancy of the Israeli

17
currency option market that was first launched in 1987. In the same light, this study
extends the literature available in Kenya on currency options, by borrowing from other
studies. A study by Ziobrowski and Ziobrowski (1992), on hedging foreign investments
in the U.S real estate market with currency options found that currency options behave
very much like an insurance policy. When used on a continuous basis, they insure foreign
investors against sudden currency losses and spread out the cost of these extreme losses
over time. Such studies have demonstrated the challenges associated with currency
options and the advantages that Kenya may obtain if a vibrant currency option market
was developed.

2.3.1 The Black and Scholes option pricing model

In 1973 Fischer Black and Myron Scholes published works in which they developed a
model that proved that the fair value of any financial asset including currency options is
worth its expected value. The model is based on the following major assumptions, the
value of the underlying currency, the strike price, the remaining time to expiration of the
option, the differentiated interest rates to apply over the life of the option, and the
anticipated future volatility of the underlying currency. The first four factors are readily
observable, but the fifth factor, volatility is not and is the most important factor
(Harrington, 1998).

Volatility measures risk of price variability, which is the annualized standard deviation of
daily percentage changes in rates. Currency markets have been very volatile over the past
few years. It is not surprising to see a currency fluctuate by as much as five percent in one
day (Harrington, 1998). The Kenya shilling has also fluctuated significantly over the past
few years with large swings especially when political risk is heightened, a graph of the
movement of the Kenya shilling is attached as appendix 4 (Reuters, 2007).

To compensate the issuer of the option for undertaking the risk, a premium is paid that is
supposed to absorb the anticipated future volatility of the option writer or issuer, between
the option issue date and the expiration date of the option (Harrington,1998). The
following is an example of the pricing of a currency option, if the price of the Kenya
shilling had a 35% chance of achieving a rate of 70 to the dollar and a 65 percent chance
of going to 62 shillings to the dollar, the fair value of the Kenya shilling would be:

18
(0.35 x 70) + (0.65 x 62) = 64.80 price of Usd/KShs or price of the dollar represented in
Kenya shilling.

The same principal applies to options, with the fair value of an option being equal to
every possible value it could achieve during its life multiplied by the probability of that
occurring (Taylor, 1999).

The Black Scholes model assumes that there are not taxes, transaction costs or margins on
any of the options contracts, secondly lending and borrowing is possible at the same rate
of interest from which accrual is undertaken over time on a continuous basis over the time
of the option contract. Thirdly it is assumed that the underlying asset in the contract can
be purchased or sold freely. Fourthly it is assumed that the underlying asset can be sold
short, and the proceeds are available to the short seller for utilization. It is also assumed
that the underlying asset pays no dividends before the maturity of the contract and that the
underlying asset remains with the same value throughout the contract period. Lastly, it is
assumed that the variability of the underlying asset price and interest remain constant
throughout the life of the contract(Taylor, 1999).

The model however allows for some adjustments of the assumptions to come up with
pricing for various options (Taylor 1999).

Below is the famous Black-Scholes model:

Call option C=S0 N(d1) – Xe-rt N(d2)

Put option P= Xe-rTN(-d2)-SN(-d1)

Where:
C – is the fair price for the option at inception
r – is the continuously compounded risk less rate of interest (risk free rate)
t – is the length of time until maturity
e – is the error term
X – is the strike price of the option
N – Cumulative normal distribution
d1 – probability that the option will end up in the money

19
 d2 – probability the expected value of the underlying asset given that the option
ends in the money
S0 – The underlying price at the outset (Taylor 1999, pg 265-267)

The one parameter in the Black-Scholes pricing formula that cannot be observed directly
is the volatility of the currency. The volatility is estimated from a historical look at the
currency movements. Advocates of efficient markets claim that volatility of currencies is
caused by the random arrival of new information about the future movements of the
currency. Others claim that the volatility is caused largely by trading. Hence, volatility
may not be always in a given range and can only be assumed to fall in a certain range.
The volatility per annum should be calculated from the volatility per trading day using the
formula (Hull, 1995).

Volatility per annum = Volatility per trading day X number of trading days per annum

The formula above has been modified and used in models that provide for option pricing.
The Black- Scholes model has proved very reliable in the pricing of options.

2.3.2 Option trading strategies

According to McCafferty (2007), various profit and loss profiles exist for purchasers of
call and put options. He reasoned that call buyers want the market price of the underlying
asset or currency in case currency options to rise so that the option gains in value and in
tandem, the buyers make money. The call writer however would want the market in the
underlying asset to go down and hence lead to the option expiring as worthless and by
extension, the call writer would make money. On the other hand, in the case of put option
buyers, they want the market price of the underlying asset or currency option to go down
so that the option gains in value and in tandem, they (put option buyers) make money.
The put option writer however would want the market price in the underlying to rise and
hence lead to the option expiring worthless and by extension, the put writer would make
money.

Below are diagrams adopted from McCafferty (2007) representing various profit and loss
profiles in currency options. Call and put options can be combined to come up with
various exotic profiles to protect an investor’s position.

20
 Profit long call- outlook for appreciation
Dr = initial option cost = maximum loos

maximum gain is unlimited

strike price

80 100 120

DR
Underlying
currency
Price
Loss

Figure 1: Long Call McCafferty (2007)

The diagram above describes an option buyer who has protected his downside risk and
ensured he has unlimited gains should the underlying move in his favour.

Profit Short Call - Outlook for depreciation

intial option payment received = maximum gain

Maximum loss is unlimited

Cr

80 100 120
Strike price

Underlying
currency
price
Loss

Figure 2: Short Call McCafferty (2007)

The diagram above represents a seller’s position for a call option. In this case, the profit
potential is limited to the value of the option received; however, the loss potential is
unlimited.

21
 Profit
Profit Long put - Outlook for depreciation
Dr= intial option cost = maixmum loss possible

Maximum gain is unlimited

Strike price

80 100 120

80 100 120

DR

Loss

Underlying
Loss
currency
price

Figure 3: Long Put McCafferty (2007)

The diagram above represents an investor who has bought a put option giving him the
right to sell the underlying asset. The potential gains are unlimited for the option holder.

Profit Short put - Outlook for appreciation

CR = Initial option payment received = maximaum gain.

Maximum loss = Unlimited

Underlying
80 100 120
CR
currency
Strike price
price

Loss

Figure 4: Short Put McCafferty (2007),

The diagram above represents a put option seller’s position. The potential gains on the
position are limited to the premium received, while the potential of losses are unlimited.

A combination is an options trading strategy that involves taking a position in both calls
and puts on the same currency positions. Below are some of these strategies commonly
known as straddles and strangles.

22
2.3.3 Straddle
A straddle involves the buying of a call and put option at the same time with the same
strike price and expiration data. The profit patterns on a straddle are illustrated on figure 5
below.

Profit A straddle

CR
80 100 120

Strike price

Loss

Figure 5: Straddle McCafferty (2007)

The strike price is denoted by 100. If the price of the underlying currency is close to this
strike price at the expiration of the option, the straddle leads to a loss. If however, there is
a sufficiently large mover in either direction of the underlying price, a big profit is
realized. A straddle is preferred when the investor expects there to be a large move in the
price of the underlying currency but does not know the direction the move will take.

For a straddle to be effective, the buyer of the straddle must have a different view from
that of the market. If the general view of the market is that there will be a large jump in
the stock price, this will be reflected in the options prices. The straddle we have discussed
above is known as a bottom straddle or straddle purchased. A top straddle or straddle
write is the reverse positions. It is created by selling a call and a put with the same
exercise price and expiration date. It is however a highly risky strategy. If the price of the
currency at expiration is close to the strike price, it leads to significant profit. However,
the loss arising from large moves in either direction is unlimited (Hull, 1995).

2.3.4 Strangle

23
When using a strangle, an investor will buy a put and a call with the same expiration date
and different strike prices. The profit pattern for this strangle is illustrated in the figure
below:

Profit A strangle

CR
80 120

Strike price

Loss

Figure 6: Strangle McCafferty (2007)

A strangle is a similar strategy to a straddle. The investor is betting that there will be a
large price movement but is uncertain of the direction, be it an increase or a decrease. In
the strangle, the price of the currency must move further than in a straddle for the investor
to make a profit. However, the downside risk if the currency price remains in a central
value is less with a strangle. The profit pattern obtained with a strangle depends on how
close the strike prices are together. The further they are apart the less the downside risk
and therefore the further a currency has to move for a profit to be realized (Hull, 1995).

2.4 Would currency options thrive in Kenya?

The financial markets have evolved to offer instruments like currency options to investors
who require to hedge transactions in foreign currencies. Below are some significant
events that have occurred resulting in the present day currency options markets in the
world. During 1944, the world’s powers met at the Bretton Woods Conference to
organize a world monetary system. This conference intended to alleviate the problems
created by the World War and promote stable currencies and global trade (Vijay, 2000).

The nations agreed to tie the values of major world currencies to the value of the United
States dollar, which was determined by the amount of gold the dollar could buy. At the

24
same time, an agreement set upper and lower limits within which exchange rate
fluctuations were permitted in response to market conditions. At the time of the
conference, the IMF set this limit at one per cent in either direction. If a country chose to
adjust the value of its currency beyond one per cent, the nation would have to change its
currency value officially in terms of US dollars. Although the Bretton Woods agreement
enabled countries to raise their currency values, in practice almost all currency changes
since then have been devaluations. The British pound, for example, was devalued twice in
1949 and again in 1967.

In the years following the Bretton Woods agreement, the US dollar emerged as the
world's leading currency. It was used as an alternative to gold when handling
international payment imbalances. In a sense, the US dollar functioned as the world's
reserve currency because it served as a unit of account, a medium of exchange, and a
store of value. Other nations kept large proportions of their international monetary
reserves in dollars (Vijay, 2000). In 1971, President Richard M. Nixon suspended the
convertibility of dollars into gold. This was a result of the problems the dollar was facing
in the 1960’s, when a combination of a US trade deficit and the oil crisis led to the
abandoning of the Bretton Wood agreement. The leading 10 nations met to chat out a new
exchange rate mechanism (The Smithsonian Agreement). They broadened the band in
which currencies could freely adjust to 2.25% above and below the pegged value of the
currencies. The agreements led to a devaluation of 8% of the dollar and a further
adjustment for the pound.

From 1973, the US promoted a floating exchange rate system where exchange rates were
determined by supply and demand forces. This ensured the Bretton Woods agreement
was dead. Subsequent attempts have been made in various regions to have a common
exchange rate and the most successful of these attempts has been the European single
currency (Euro) (Vijay, 2000). After 1973, the currency markets began to operate by
forces of supply and demand. Currency markets developed and volatilities in these
markets increased. According to Vijay (2000), any attempts to control these fluctuations
have failed, as was the case with the European exchange rate mechanism (ERM) when
the currency speculator George Soros took concerted speculative attacks on the pound
that led to substantial fluctuations and the eventual withdrawal of Britain and Italy from
the ERM.

25
Such developments have led to investors preferring a sure bet on the currencies exchange.
Market participants have developed derivatives to assist in hedging of business
transactions. A derivative is an instrument “whose performance is based on (or derived
from) the behavior of the price of an underlying asset (often known simply as the
“underlying”). The underlying itself does not need to be bought or sold.” (Taylor, 1997
p. 169).

In relation to the Kenyan set up, some scholars have examined the development of the
Kenyan market. Leiyan (2001) for example, studied the product innovations that banks
could come up with to respond to the financial liberalization that was going on around the
world. Options were one of the areas of innovation in the Kenyan market introduced as a
tool to help companies reduce the exposure to currency risk. Such products provide
clients with alternatives for hedging any exposure that they may be exposed to while
engaging in international trade.

2.4.1 Risks on option trading

Hull (1997), states that no book on derivatives would be complete without mentioning the
huge losses to some of the derivative market participants. He points to losses incurred by
Gibson Greetings, Proctor and Gamble, Kidder Peabody, Orange County, Barings and
most recently Societe Generale and Lehman Brothers. In the case of Barings, a young
trader known as Nick Leason who in 1995 was only 28 years old over-traded in
derivatives in Singapore, in a subsidiary of Barings Bank (a United Kingdom bank), and,
at the end of it all, lost a total of 827million pounds or about Us dollars 1.4 billion, which
was twice the bank’s capital. At the end of the day, the actions of one dealer led to the
liquidation of Barings Bank in the same year.

The losses incurred especially after the high profile cases, made many corporates wary of
derivatives. Some of them even instructed non-usage of such products. Hull (1997)
further states that derivatives can either be used to hedge or speculate in the underlying
asset. Hence, they can either increase or reduce risk as hedgers or speculators use them
respectively. The losses that resulted in all the above cases were because of inappropriate
use of derivatives. The responsibility to manage risk prudently was abused by those to
whom it was given, taking big bets on the future direction of the markets, which resulted

26
in disaster. Management should ensure that derivatives are used in accordance with well
laid down policies and controls.

2.4.2 Legal background to trade options in Kenya

The growth of options and derivatives in general seems to have been ignored and
therefore omitted in Kenya’s statutes. The Banking Act Cap 488 (2008) of the laws of
Kenya does not mention derivatives, their application, or the extent to which an
organization can trade the same. The Banking Act Cap 488 section 33 (4), which
empowers the Central Bank of Kenya to issue guidelines to commercial banks to ensure a
stable monetary system, fails to mention options as part of the basket of foreign exchange
products in the market. The document mentions treatment of spot transactions, forward
contracts, and swaps extensively. It however, does not clearly define the treatment of the
off balance sheet options by the regulator.

The guidelines for filling in commercial bank statistics for submission to the Central
Bank of Kenya, mention derivatives under the heading “Statistical treatment of financial
derivatives”. The documents states: “The treatment of financial derivatives is still being
developed internationally. Currently there is no standard statistical treatment.
Consequently the Central Bank of Kenya will revert to all reporting institutions when a
common treatment of the same is available (CBK, 2009).”

The financial reporting in Kenya is done in accordance with the International Accounting
Standards (IAS) 32 and IAS 39 that cover the recognition and measurement of financial
assets and currency options. The two standards cover the financial instruments, disclosure
and presentation in IAS 32 while IAS 39 looks at financial instruments, recognition and
measurement. These two accounting standards are complex and form the basis of
reporting on derivatives and by extension currency options. The standards have various
provisions for recognition of off balance sheet items and provide directions towards the
treatment of derivatives in the balance sheet and profit and loss statement (HM Revenue
& Customs, 2009). These issues relating to the accounting standards are however beyond
the scope of this study. It should be appreciated that Kenya follows International
Accounting Standards when it comes to reporting of derivatives on a company’s books of
accounts.

27
The provisions surrounding derivatives as mentioned above, especially concerning
institutions under the Banking Act Cap 488 are vague and prone to abuse by commercial
banks, micro-finance institutions, mortgage institutions, forex bureaus, and deposit taking
cooperative societies. Muchiri (2000) studied the Micro-finance industry in Kenya. The
study brought to the fore the benefits of having regulations or laws that cover an industry
or product. The Micro-finance Act has ensured the growth of Micro-finance in Kenya.

Regulation covering derivatives and options specifically to ensure controlled growth of

these products would be a welcome development in the Kenyan market. The concern
about legislation is important given the nature of financial transactions that have made the
world slide into a global recession in 2009 having come about from derivative
transactions that were poorly supervised starting with the subprime mortgage crisis in the
United States and thereafter followed in Europe by events such as the Greece debt crisis.

2.4.3 Global financial crisis

The subprime mortgage crisis originated from large banks in America packaging their
mortgage loans into instruments know as securitization that allowed them to pool their
loans into saleable assets. The banks could then be sell off the securitized loans to a third
party and hence transferring risk from them to third parties. Banks like Lehman Brothers
which were investment banks and not commercial banks became the main players in
buying mortgages in order to later securitize them and sell them off at high profits. The
banks enjoyed as property prices continued to rise in the nineteen nineties as many
investors thought the global boom would not end (Shah, 2010).

In 2007 however, there was a loss in confidence in the value of subprime mortgages in
the US economy that lead to a liquidity crisis. By 2008, world stock markets around the
globe crushed and became highly volatile. Consumer confidence around the world hit
rock bottom leading to a slowdown in consumption as investors tightened their belts in
expectations of hard times ahead. It was clear that the financial markets were not well
regulated and derivatives like mortgage backed securities and collateral backed
obligations were not well understood by both market players and regulators.

On 14th September 2008 Lehman Brothers in the United States collapsed. This brought
the global financial crisis to the open and governments around the world struggled to try

28
and save large financial institutions within their economies by using bailouts to prevent
them from collapse. The spending was on an unprecedented level since the end of world
war two, causing a major dip in confidence in the global financial system. Banks refused
to lend fearing that they would not be able to recover their capital. The result of which
was a general global economic slowdown. Although Africa did not suffer much, we have
experience serious spending cuts to critical programs such as health and education
programs. Below is a diagram indicating the spending by governments to bail out US and
European financial companies in the wake of the global economic crisis (Shah, 2010).

Figure 7: Global Financial Crisis and Cost of Bailouts

2.4.4 Foreign exchange in emerging markets

Currency markets have evolved at different speed from 1973 when the floating exchange
rate system came into use (Vijay, 2000). Many markets have evolved at different speeds
with different regulations in the market, and level of sophistications being key. According
to Anuradha (2007) the Indian currency markets where only partially deregulated in 1993
but since then the market has made swift progress towards using currency options. He
goes on to explain that the Indian rupee has foreign exchange products in form of rupee

29
swaps and currency options. Rupee currency options are allowed where there is an
underlying foreign exchange exposure. Authorized bank dealers are allowed to enter into
hedging transactions that include currency options with persons that have exposures in
Indian rupees. Examples of companies that have carried out substantial currency options
hedging were Reliance Industries, Mahindra, Tata and Infosys among others.

According to Dixit et al. (2009), African currencies were greatly affected by the global
financial crisis with depreciation of up to 20% of some currencies against the world
reserve currency the US dollar during the crisis. This trend is expected to persist with
volatility in African currencies continuing, so long as central banks on the continent
continue with floating exchange rate regimes. In Kenya for example, the Kenya shilling
depreciated sharply at the onset of the global financial crisis in June 2008 to March 2009
by over 11%. Traders were exposed to this depreciation and had to pay more for imports
during this period.

According to Saxena (2007), properly developed financial markets ensure that liquidity is
developed and derivatives can be provided in the market. This maturity profile of
securities is developed into a long term yield curve. This yield curve will enable local
banks to provide long term financing for infrastructure projects and at the same time
enable investors to provide investments to long term development projects.

To develop financial systems Saxena (2007), states that banks must develop rapidly and
ensure they provide adequate financial services to the economy. Banks provide a platform
for the development of a credit system in the economy and an avenue for long term debt
markets to develop. They promote the issuance of new financial instruments in an
economy by providing underwriting services or improving investment or hedging
opportunities. In a competitive environment these developments will lead to a healthy
vibrant financial system, where new products like options may be offered. Africa is at a
disadvantage compared to economies of Latin America and Asia in this regard.

He further explains that foreign exchange markets must be developed. Foreign exchange
markets make it possible for residents to raise capital directly in foreign debt markets. It
also provides hedging instruments to the market that enable the lengthening of domestic

30
debt market maturities. Liquidity in the market comes from cross border trade that
enhances capital flow.

According to Saxena(2007), outside of South Africa, currency and derivative markets

tend to be underdeveloped. He documents that derivative markets outside South Africa
generally have the market generally concentrated in the control of a few commercial
banks with only a few financial transactions among them. Secondly, there are often
restrictions in the foreign currency markets that limit the depth to which players can
participate efficiently. Lastly, there are normally very high formal costs that restrict the
use of derivatives and hence there is limited usage of any financial instruments.

In Eastern European counties, the foreign exchange markets have developed significantly
between the year 1999 and 2000. In the case of Poland and the Czech Republic, after a
period of limited convertibility the currencies have become increasingly traded
internationally and currency options have developed to reduce risk in financing
operations. These emerging market economies have significantly grown in options use
with a corresponding increase in volatility as they move from a controlled to a liberalized
market (Morales, 2003). To relate to a market closer to Kenya, the South African
financial markets have developed significantly since the early 1990’s when options were
introduced in areas of commodities and currencies. Below is a table showing summary of
growth of the South African derivatives market as compared to emerging market volumes
(Adelegan, 2009).

Table 2 South Africa trading volume of over the counter derivatives

Volume 2001 2004 2007 Growth rate

US dollars(millions)
Currency 7,858 8032 10,568 2.21
derivatives
including currency

31
options

Interest rate 578 2,961 4,474 412.28

derivatives
Total 8,436 10,375 15,042 22.98

Total in emerging 160,375 240,389 151,787 49.89

markets
Share of emerging 5.26 4.32 9.91
market

Source: Bank for International Settlements, Triennial Central Bank Survey, 2007.

The South African market formed about 9.1% of the emerging markets derivatives.
According to Adelegan (2009), other countries in Africa such as Kenya can learn from
the South African market about the benefits of the developed derivatives market. The
economies can self insure against volatile capital flows in the international markets. The
development of a local derivative market will provide alternatives for managing financial
risk.

With the growth of the market, caution must be taken to ensure proper regulations are put
in place. Increased interest from international investors increases liquidity but has the
potential to also destabilize the financial system if the market is not deep enough. It is
therefore essential that the market has proper rules set out, proper macroeconomic
policies and political fundamentals maintained to attract and sustain the investor interest
in the derivative market (Adelegan, 2009).

It is essential to promote the growth of the derivatives in a market like Kenya as it will
offer a broadening of investor opportunities in the market. This can help in the
diversification of portfolios and reduce on risk. The Kenya market can target to grow
derivatives with the proper consumer protection rules in place. The country can benefit
from insurance from volatility of capital flows. The key especially with currency options
will be the management of seasonal risk arising out of currency fluctuations (Adelegan,
2009).

32
2.5 Chapter Summary
This chapter has looked at the growth of the options markets and trends within the foreign
exchange markets. The structure of the currency options was also reviewed. The chapter
reviewed the kind of clients that would have the desire to either purchase call or put
options. The various types of options in the market namely the European, Asian and
American options were discussed.

An explanation of how options are priced with the Black Scholes model is given. Option
trading strategies are explored with a culmination of combinations such as straddles and
strangles laid out. A comparison between currency options and other products in the
market like forward foreign exchange contracts is discussed.

The review looks at research carried out in the past on similar or closely related topics to
pinpoint gaps in knowledge. The review drew on Alaro (1998) and Ochong’s (2002)
studies that look at currency options in Kenya and commercial treasury management in
organizations respectively. The study reviews developments especially in other emerging
markets like Kenya, South Africa, India and Eastern European countries. The chapter
touches on the global financial crisis that was triggered by the collapse of Lehman
Brothers in 2008. The chapter explains the amount of funds used to try and stabilize the
economies of the United States and European economies and explains why less developed
economies like Kenya did not get affected much by the global economic meltdown
thereafter.

The chapter touches on a brief review of the framework provided by the Central Bank of
Kenya and other statutes that surround the financial markets to get direction on the
working of currency options. The next chapter will discuss the methods of data collection
and analysis that were employed in this study.

CHAPTER 3

33
3.0 RESEARCH METHODOLOGY

3.1 Introduction
This chapter looked into the methodology that was used in carrying out the research.
Both primary and secondary data were collected to explain the state of the currency
option market in Kenya. The study explored the usage of currency options in Kenya and
to what extent the currency option market could be developed. The data collection
methods utilized focused on the subject topic. The chapter also covers the general
research design, the population in the research and sample techniques used. Further to
this, the data collection methods and data analysis techniques are covered. Finally, the
chapter concludes with a brief summary.

3.2 Research Design

The study design focused on use of questionnaire survey methodology to gain an
appreciation of what the currency dealers feel about the subject matter. The research
explored the nature of currency options in the Kenyan market. The questionnaires that
were administered to respondents were semi-structured in order to elicit the most
comprehensive responses; the respondents also received questionnaires via e-mail. The
data collected focused on the usage and knowledge of currency options by market players
and the level of development of the Kenyan financial system to accommodate currency
options. The questionnaire was designed to elicit recommendations towards the
improvement of the financial market in Kenya and ensure increased usage of currency
options. The data collected provided a framework on how instruments such as currency
options can be made functional to a modern businessperson (Saunders et. al, 2009).

The research therefore was exploratory in nature as it describes the current currency
market in existence in Kenya and demonstrates the importance of understanding currency
options as tools that can be used by businesspersons to hedge against currency exposures.
The research was limited to answering the research questions posed. While the researcher
tried to provide a theoretical framework on the use of options, in general the study
narrowed in on the Kenyan setup evaluating how useful options are to the market and
whether there is any substantial interest in their usage.

34
3.3 Population and Sampling Design

3.3.1 Population
The study identified the target population from whom data would be collected as all
dealers working in banks in Nairobi. Nairobi is the location of headquarters of all
commercial banks in Kenya. According to Saunders et. al. (2009), students can limit their
population to specific areas in order to come up with a sample size. The population
sample was restricted to persons who trade in foreign currency regularly at the
commercial banks. Forty two commercial banks registered by the Central Bank of Kenya
were identified for collection of data. Two dealers in each of the banks as per the Central
bank of Kenya list of commercial banks formed part of the population sampled. The study
identified currency dealers because of their daily interaction with clients interested in
transacting foreign exchange. Dealers are the dominant players in the currency market.

3.3.2 Sampling Design

Due to the specialized nature of this study, and how it relates to a specific market
segment, the study segregated the market conveniently into commercial banks who the
researcher perceived to be active players in the foreign currency market. The study used
this sample as a representation of the commercial activities in the Kenyan foreign
exchange markets. As such, all 42 commercial banks were included in the sample. The
list of banks was obtained from the Central Bank of Kenya’s publication of commercial
banks on their website. Two randomly selected dealers from each bank were sent
questionnaires (Appendix E). This was thought to generate adequate responses to
represent the currency market in Kenya. Thuku, (2000) used similar sampling techniques
to study information efficiency in forex bureaus in Kenya, while Ochong, (2002)
employed similar methods, sampling companies on the stock market to come up with
conclusions on the working and management of commercial treasuries in the private
sector. Thereafter, the study used probability-sampling techniques to generate primary
data, and draw conclusions on the population.

3.3.3.1 Sampling frame

35
The research sample frame consisted of commercial bank treasury dealers in Kenya. The
list of dealers was obtained from the Association of Kenyan Bank dealers (ACI Kenya).
This list was thought to be sufficiently comprehensive to capture most of the target
population. Probability sampling was used to collect data within the sample frame
(Saunders et. al., 2009).

3.3.3.2 Sample size

Dealers in all commercial banks were targeted. This provided a one hundred percent
census population. Thereafter random samples of two respondents within each
commercial bank dealers were drawn and questionnaires sent to them. The nature of
currency transactions does not vary from one bank to another. It was expected that the
responses on the samples would not vary from bank to bank. Dealers were expected to
provide generic data. As such, the variations between the banks were reduced. The
sample size provided adequate results by getting responses from a majority of the
commercial banks in Kenya hence rendering the data reliable.

Table 3 Sample size distribution

Banks Number Sampled Total Percentage

Commercial banks 42 42 Banks 100%
Sample per bank 2 174 population 48%
Total sample 84

3.4 Data Collection Methods

The study relied on primary and secondary data collection methods. Primary data
collection was provided from a survey research using questionnaires. The questions were
self filled by the recipient and returned for analysis on the subject matter. A response rate
of 50% was the target out of the questionnaires sent out.

Secondary data was obtained from books, journals, and encyclopedias. A critical look at
historical data provided an understanding of currency markets and how the usage of
options could be beneficial in the Kenyan setting.

36
3.5 Research Procedures

The research was broken down into planning stages, budgeting, literature review,
secondary data collection, questionnaire designing, pilot testing, primary data collection,
analysis, review, and final report writing. Suitable gnat charts were utilized to ensure
efficient utilization of time while proper budgets were drawn for financial optimality.

The questionnaire as the data collection instrument was pre-tested to ensure its validity
and reliability for the survey. This enabled the researcher to identify vague questions and
ensure that the instrument measured the concepts intended as well as checking for flows
and biases.

Pre-testing was conducted on ten participants with similar characteristics as those to be

included in the study sample. The ten respondents were not part of the sample in the main
study. The pilot testing was used to improve the final questionnaire sent out to
responders. This ensured that the data collected was adequately captured and the
instruments reviewed to ensure suitability.

According to Cooper, et al (2001), a period shall be set aside to notify the potential
recipients of the questionnaires that the research will be carried out to ensure adequate
responses. This leads to the all important data collection phase when questionnaires are
administered and collected. The questionnaires were administered via email. The
questionnaires were emailed to responders as a form, which they were to fill out and send
back by return e-mail. The nature of the questionnaire and the mode used to send to
respondents saved both time and money in questionnaire issuance and gathering of
appropriate feedback. In the event that there was lack of response from any respondent
for a period of more than one week, a telephone call was made to follow up and ascertain
whether there was a problem or if there was need for some clarification.

The administering of questionnaires lasted for a period of twenty days. The first week
took care of pilot testing and appropriate reviews in addition to notifying respondents of
the upcoming questionnaire. The next period of approximately two weeks involved

37
administering the questionnaires. Then there was the time to let respondents fill out the
questionnaires and for the researcher to follow up on any questionnaires outstanding.

3.6 Data Analysis

Data collected was coded and analyzed. This process involved coding of all responses,
which were then fed into a computer and analyzed using the standard statistical package
for social sciences (SPSS). Descriptive statistical techniques were applied to the data.
This involved reducing the accumulated data into a manageable size by looking at mean,
averages, percentages and patterns that the data had produced. This involved applying
statistical and descriptive techniques to the data and exploring various relationships. It
also involved viewing for consistent results that could be interpreted and linked to answer
the research questions. This analysis was able to generate adequate results on the research
questions leading to conclusive results. The results are presented in form of tables, figures
and graphs in the next chapter.

3.7 Chapter Summary

This chapter focuses on research methodology and research design, which was a survey
questionnaire. The chapter explains how data was collected and analyzed. The
questionnaire administration including pilot testing of the research instrument, are
covered. The study was limited to Nairobi region and focused on dealers in commercial
banks. Data collection methods drew reference to literature on research that provided a
theoretical framework. The analysis of the data was undertaken using statistical tools and
computer programs. The next chapter gives results of data gathered using the
methodologies given in Chapter 3.

38
 CHAPTER 4

4.0 RESULTS AND FINDINGS

4.1 Introduction to Data Analysis

The results of the data analysis and the findings are presented in this chapter. The
presentation will is in form of graphs, and tables. Eighty-four questionnaires were
administered through emails that were sent out to dealers who were expected to answer
and elaborate on their knowledge of currency options. The responders were called and
asked to fill out the questionnaires and email them back with the answers. Persuasion by
phone calls was used to encourage all responders to answer the questions and return the
results to the researcher. Out of the 84 dealers questioned, 48 responded. This gave a
response rate of 57% on the questionnaires administered. The data collected was coded
and analyzed. The analysis involved the use of frequencies, percentages and mean scores.

4.2 General Information

The respondents were asked to provide brief background information that was not
personal in nature. Due to the sensitive nature of the banking industry, respondents were
not asked to give their names in order to remain anonymous. The respondents were asked
to give an idea on what type of organization they work for. Since the research
concentrated on only bank treasury dealers, it was important to know what type of banks
they were from, be they small banks, medium, large or multinational. All the
questionnaires were administered in Nairobi where the headquarters of all banks in Kenya
are located.

4.2.1 Description of the bank

According to figure 7.0 below, the number of responders was generally evenly distributed
between large and multinational banks forming 31% each. Medium sized banks had 25%
of the responders while the small banks comprised 13% of the responders.

39
 Chart Indicating Responders

Large banks Multinational

31% 31%
Multinational
Small bank
Medium banks
Large banks
Medium
Small bank
banks
13%
25%

Figure 8: Segmentation of respondents by type of bank

4.2.2 Years of Service

The treasury personnel that were interviewed had varying experience at their current
positions of service. The questionnaire sought to find out how long the dealers had served
in their present positions. Data revealed that 56% of the treasury personnel had worked in
their current roles for over 5 years. Treasury personnel who had worked for between 2
and 5 years formed 25% of the population while those with experience between 0-2 years
formed 19% of the responders that provided feedback to the administered questionnaires.
A summary of the data on treasury dealer’s length of service is provided in figure 8.0.

Years Served in Treasury

19%
0-2 years
2-5 years
56% 5 years and above
25%

Figure 9: Length of service by treasury personnel

Figure 8.0 shows the average years of service of the personnel sampled in the survey.
From the table above you can see that 56% of those interviewed had served for 5years

40
and above. Nineteen percent of the respondents 2 years or below and 25% of the
respondents had served for 2-5 years.

4.3 Do Currency Options exist in Kenya?

In this section, respondents were asked to answer questions around their personal
knowledge of currency options. Opinions were also sought on the banks’ personnel
knowledge of currency options. The questions further, sought to establish the percentage
offering of a banks basket of treasury products.

4.3.1 Currency Option Knowledge

The respondents were first asked to provide their personal assessment of their own
knowledge of currency options as a matter of professional expertise. Respondents offered
the following replies as per figure 9.0 below.

Currency Options Knowledge

% 80
r 68.75
70
e 60
s 50
p 40
o 30
n 20 12.5 12.5
s 10 0 6.25
e 0
Excellent Very good Good Average Poor
Ranking

Figure 10: Ranking of knowledge as a percentage of respondents

According to the average rankings by the respondents, about their own knowledge 12.5%
of those polled claimed to have poor knowledge. Slightly over six percent (6.25%) of
those polled claimed to have average knowledge on currency options, 68.75% said they
had good knowledge while 12.5% said they had very good knowledge on currency
options while none of the respondents claimed excellent knowledge.

41
4.3.2 Provision of currency options
We then asked the respondents, whether the provision of currency options had a bearing
on the knowledge treasury personnel possessed. The question tried to establish if the
respondents perceived any link between the knowledge they had on currency options and
their ability to deliver the same to clients. The question had a yes or no answer, which
elicited the response shown in figure 10.

Respondent’s assessment of the role knowledge plays in

provision of options

19%

yes
no

81%

Figure 11: The role knowledge plays in provision of currency options

Eighty-one percent (81%) of the respondents replied yes while 19% replied no to the
question on whether the provision of currency options had any link to the knowledge
treasury staff possessed.

4.3.3 Inquiries Received From Clients

To determine whether there was sufficient demand for options in Kenya by banking
sector clients, the respondents were asked whether they received sufficient inquiries to
provide currency options to the clientele they interact with in the banks. Figure 11 gives
the responses.

42
 Inquiries from Clients Pertaining to Currency Options

NO, 44%

YES, 56%

NO
YES

Figure 12: Inquiries received from clients

Less than half of the respondents (44%) said they had not received any inquiries from
clients directed at currency options, while 56% of the respondents said they had received
some inquiries.

4.3.4 Feedback on which sector of economy generated more queries

The respondents were also asked to provide feedback on which sectors of the economy
generated the most queries as pertained to currency options. According to Figure 12 on
the next page, 38% of the respondents saw the manufacturing sector as providing the
largest share of demand for currency options, 21% view oil companies as the sector that
provided demand for currency options, 12% of demand were from telecommunication
companies and 9% from airlines. Other sectors showing interest were transport and
tourism industries with 6% each. The sectors of horticulture, agriculture and Ngo’s had
each 3% of total demand. From the responses, there were no inquiries from the
government sector.

43
 Sector Demand for Currency Options
Transport
6%
Horticultural
3%
Agricultural
3%
Telecommunication
12%
Airlines
9%
Government 0%
Tourism
6%
Ngo's
3%
Oil companies
21%
Manufacturing
38%

0% 10% 20% 30% 40% 50%

Figure 13: Sectors of the economy that demand options

To establish the total basket of currency options in Kenya as a percentage of the banks’
total offering of treasury products, respondents were asked to give a breakdown of their
banks’ percentage offering of treasury products. The breakdown was to detail the number
of products that the various banks offer to clients from the treasury end. This information
will provide the breakdown of what specific product are on offer in the Kenyan financial
markets. Below is a summary of the respondents’ replies.

Table 4 Percentage of derivatives provided by banks in Kenya

Distribution
Frequency Percentage
Transaction types
Spot transactions 36 76.00%
Forwards 10 20.00%
Currency options 2 4.00%
Total 48 100.00%

Banks offered spot foreign exchange contracts 76% of the time, while they offered
forward contracts to clients 20% of the time. They were able to provide currency options
about 4% of the time as a product offering in their treasury departments.

44
4.4 Why don’t commercial banks provide currency options in Kenya?

In the third section of the questionnaire, we sought to know what might be hindering the
growth of an over the counter option market in Kenya. We also sought to know from
currency dealers how various players in the industry could facilitate the improvement in
the currency options market.

4.4.1 Reasons why growth of over the counter options market in Kenya is hindered

The first questions sought to know the main reasons that hindered the development of an
over the counter market in Kenya. The dealers sampled had the following replies
according to table 5.0 below.

Table 5 Hindrances to the growth of over the counter options market in Kenya

Reasons hindering growth Distribution

of over-the-counter F % Mean N Std.
currency option deviation
Lack of knowledge, by 18 19% 19 1
dealers of currency options
Low demand by customers 33 35% 35 1
for currency options
Lack of guidance by 21 23% 24.5
regulators (C.M.A and
C.B.K)
Fear by banks’ management 21 23% 24.5
of the risks inherent in 2 2.1213
currency options.
Total 93 100 25.75 4 6.8007

According Table 5 above 35% of the respondents thought that low demand by customers
was the reason hindering the growth of the over-the-counter options market in Kenya
while 19% were of the view that lack of knowledge by currency dealers was the main
reason hindering growth. Lack of guidance by regulators (Central bank of Kenya and the
Capital Markets Authority) and fear from commercial banks’ top management were given

45
by 23% of respondents as reasons encumbering growth in over the counter currency
options.

4.4.2 Benefits of using currency options by clients

To determine whether clients would benefit from the usage of options, by protect
themselves from currency fluctuations, we asked the respondents to what degree they
agreed or disagreed with the statement that clients would derive benefits from currency
options. According to the data collected and shown in table 5 below, 37.5% of the
respondents strongly agreed, 62.5% agreed with the statement while none disagreed or
strongly disagreed that clients would benefit from using currency options to hedge their
exposures to foreign exchange.

Table 6 Benefits of using currency options by clients

Distribution
Frequency Percentage
Response
Respondents strongly agree 18 37.5%
Respondents agree 30 62.5%
Respondents disagree 0 0%
Respondents strongly disagree 0 0%
Total 48 100%

4.4.3 Customer Knowledge on Currency Options

We then asked the respondents whether they thought the clients who deal with them have
adequate knowledge on currency options. Figure 14 below gives a depiction of the
responses.

46
Figure 14: Customers knowledge of currency options

According to figure 14, 38% of respondents who interacted with treasury dealers thought
bank customers had an average knowledge of currency options, 31% perceived customers
to have poor knowledge while 15% of respondents perceived customers as having good
knowledge. Ten percent of respondents perceived to have very poor knowledge while 5%
of the respondents thought customers had excellent knowledge on currency options.

4.4.4 Percentage of Kenyan Currency market taken by options

The final part of the questionnaire looked into the state of the Kenyan currency market
and how it could be improved to create a vibrant currency options market. Respondents
were asked to pick from a list the percentage of the overall market that made up Kenya’s
currency options market. All the respondents picked zero percentage for the response.

4.4.5 Role of CBK and CMA in provision of currency option

Respondents were then asked whether the Central Bank of Kenya and the Capital Markets
Authority had a role to play in the provision of currency options to the Kenyan market
participants and whether there was need to provide support to market players to develop
the currency options market in Kenya.

Figure 15 represents the different responses choices. Nineteen percent (19%) of the
respondents think there is no role for the Central bank of Kenya and the Capital Markets

47
Authority in the development and support of market players in the provision of currency
options while 81% of the respondents think there is a role for the two bodies (Figure 15).

Importance of CBK and CMA in Provision of Options

19%

81%

Yes No

Figure 15: Role of CBK and CMA in provision of currency options

The respondents were asked to suggest areas that they believe the regulators being the
Capital Markets Authority and the Central Bank of Kenya, needed to pay attention to in
order to develop the Kenyan currency options market. Figure 16, shows that 48% of the
respondents wanted increased development in legislative and regulatory framework as
pertains to currency options, 24% of the respondents wanted the risk management areas
associated with currency options to be given more attention while 12% of wanted the
regulators to try to develop the skills and capacity of banks. Only 6% of the respondents
wanted Capital Markets Authority and Central Bank of Kenya staff to be trained in order
for them to understand currency options while 10% wanted to see increased public
awareness on currency options in Kenya.

48
Figure 16: Areas requiring development by CMA and CBK

The questionnaire asked the respondents to provide feedback on areas they thought were
hindering the provision of currency options to bank clients. Respondents who said that
lack of knowledge was the main problem hindering the provision of currency options to
clients in Kenya were 28% while 23% chose a low level of risk appetite by banks in
Kenya was the main hindrance. Almost 25% of respondents (24.77%) said that it was the
high cost associated with currency options that was slowing the growth of the options
market while 23.85% of the respondents said it was the low level of demand by clients
(Figure 17).

Factors Hindering Provision of Options

23.85% Lack of product

27.98% Knowledge
Low risk by banks

High cost of Options to

Clients
24.77% Low demand by clients
23.39%

Figure 17: Factors hindering provision of currency options

49
4.5 Would the currency options market thrive in Kenya?

4.5.1 Ways to improve the provision of options in Kenya

Finally, the respondents were asked to suggest areas for improvement in the currency
options market. Some of the respondents were of the view that in order to develop the
currency option market in Kenya extensive training needed to be undertaken for both the
treasury personnel and customers who would require currency options. The training in the
view of the respondents should cover various aspects such as accounting procedures for
currency options, risk management training and awareness education to bring customers
up to speed with advantages of currency options.

4.5.2 Regulatory Framework

There were suggestions for a legal framework to regulate the development of the options
market. It was further suggested that banks invest in software that will help them book
options as derivatives in their books. Some of the respondents were of the opinion that
there should be relative stabilization of the interest regime in the country in order to avoid
wide distortions that may make options risky to commercial banks.

There was a suggestion on the need to educate the public on the advantages of currency
options as compared to other hedging methods. The education should be extended to the
staff to be tasked with regulating the currency options market. The education provided
would ensure that currency options are better understood by the general public and all
bank staff.

4.6 Chapter summary

This chapter has discussed briefly the findings of the study. It has summarized the results
in tabular and charts form. The study had a response rate of fifty seven percent with forty-
eight of the eighty-four dealers responding to the questionnaire. The respondents’ banks
were classified into small, medium, large and multinationals. Of those interviewed 56%
had worked for 5 years and above, 25% for 2-5 years while 19% of them had worked for
0-2 years.

50
A majority of the interview dealers claimed to have good knowledge of currency options
(68.75%) while 12.5% had very good knowledge. Only 6.25% of the respondents had
poor knowledge on currency options. Knowledge plays a large part in the understanding
and provision of currency options to clients. More than half of the respondents (56%)
received inquires from clients for provision of currency options. Most of the inquiries
were from the manufacturing sector at 38%, followed by oil companies (21%), and the
telecommunication companies (12%) among others. Results on hindrances to the growth
of over the counter currency options and the role of the regulators are given. Most
respondents (35%) thought hindrance was due to low demand by clients. Lack of clear
guidance by the regulators that is the Central Bank of Kenya and the Capital Markets
Authority also contributed. Respondents’ suggestions on how to improve and expand the
options marked were also given.

Chapter 5 will discuss the results, give conclusions, recommendations and suggest areas
for further research based on the findings analyzed and stated in this chapter.

51
 CHAPTER 5

5.0 DISCUSSION, CONCLUSIONS AND RECOMMENDATIONS

5.1 Introduction

This chapter combines the objectives of the study as seen in chapter one with the results
which we have just discussed. The chapter is organized as follows: sections 5.2 gives a
summary of the study and its major findings, section 5.3, a discussion of the findings with
subsequent subsections based on each of the specific objectives, section 5.4 gives the
conclusion to the study while section 5.5 provides recommendations for improvement of
the currency options market within the context of this study. We conclude this research
with a section on recommendations for further research on the subject of currency options
within the Kenyan market.

Summary

The major purpose of the study was to investigate the existence and usage of currency
options in the Kenyan foreign exchange market, and to suggest ways to remove or limit
hindrances to the growth of the currency option market. The objectives of the study were
firstly to determine whether banks in Kenya provided currency options. Secondly to
establish whether there were any hindrances to the development of currency options in
Kenya and finally to suggest improvements to the currency option market in Kenya.

The study was descriptive in nature and attempted to explain the use and benefits of
currency options. The study reviewed the use of currency options and alternatives
available to clients for hedging foreign currency exposure. The literature review analyzed
the growth of the foreign exchange market and the emergence of currency options in the
over the counter markets in the world. A review of the types of options and uses of
currency options in the financial markets was done with a focus on whether there was in
existence sufficient regulation to support growth of a currency option market in Kenya.

The study used questionnaires to collect data from dealers in the 42 commercial banks in
the Kenyan market to gain an appreciation of who used currency options, what level of
knowledge the market had of currency options and whether market participants thought

52
the regulators were providing enough support for the growth of a currency options
market.

The study found that majority of the dealers sampled had knowledge on currency options
with 68.75% stating they had adequate knowledge. Majority of the respondents said their
banks had received inquiries from clients to provide currency option from time to time.

Secondly 81% of the respondents thought the Central bank of Kenya and the Capital
Markets Authority had a major role in the growth of currency options. Twenty-three
percent of respondents attributed the slow growth of a currency options market to low risk
appetite by Kenyan commercial banks. The research found that only 4.1% of the
commercial banks in Kenya offered currency options as one of their treasury products.

Thirdly, legislation was found to be a factor impeding the development of a currency

option market. The study also noted that to increase access to currency options, increased
product knowledge by clients and bank personnel was necessary. Respondents suggested
that extensive training covering areas around accounting procedures for options, increase
risk management awareness and the advantages of using currency options as hedging
techniques for currency fluctuations be undertaken.

5.3 Discussion

5.3.1 Do currency options exist in Kenya?

The results obtained showed that commercial banks in Kenya provided currency options
but only at a low level (0-5%) of the commercial banks’ treasury products. Currency
options formed 4.1% of the product offering by commercial banks. This is a very small
percentage but understandable given the complexity of the product. Options markets
thrive in an environment of a thriving economy (Alaro 1998). At the time of this study,
the Kenyan economy was not performing well as it was just coming out of the effects of
the post election violence, the global financial crisis and the drought (Kenya Economic
Survey 2010).

The market in Kenya is still in its infancy which is what Yehia (1999) found about the
Israel market. By the time Yehia studied the Israel market, it had been in existent for just

53
over a decade having been started in 1987. It is not clear when the Kenyan currency
options market was started. From his review, Alaro (1998) had indicated the existence of
currency options market in Kenya in the 1990s. This seems to contradict Saxena (2007)
who was of the view that no derivative market outside of South Africa had developed in
Africa. Ochong (2002), pointed towards the increased use of options in the Kenyan
market. However, according to the current survey very few banks in Kenya (only 4% of
bank treasuries) provide currency options to clients.

A review of the study done by Adeglan (2009) shows the benefits derived by the South
African financial market from the provision of currency options. The current study noted
that a majority of the currency dealers surveyed indicated that similar benefits would
accrue to the Kenyan market on adoption of currency options.

5.3.2 Why don’t Commercial Banks provide Currency Options in Kenya?

From the survey not many banks in Kenya provide the currency options mainly because
of what most of the dealers surveyed identified as low demand for currency options by
clients (Table 4). This is surprising since the same respondents had stated that they
received inquiries on currency options from various clients in various industries Figure
12. However, the low demand may be due to the state of the economy at the time of the
research as discussed in 5.3.2.

The second reason chosen was fear by banks of the risks involved in currency options
market. There are major risks involved as can be seen from the collapse of Barings bank
(Hull 1997). There was also the case of the financial crisis in the United States with cases
such as Lehman Brothers that were thought to be the result of funds hedging mortgage
products resulting in the sub-prime mortgage crisis. The problems in the United States
affected more or less the whole world due to the nature of global trade. It is thus not
surprising that respondents would consider fear of risks involved as an obstacle to the
development of this market sector. The irony is that the market is supposed to act as an
insurance against risks of currency fluctuations (Ziobrowski and Ziobrowski 1992).

From the results, a number of clients from different industries made inquiries, as
indicated in Figure 11 in chapter 4. It is not surprising that most inquiries came from the

54
manufacturing sector followed by the oil sector. As Ziobrowski and Ziobrowski (1992)
observed, currency options behave like an insurance policy. They insure clients’
investments against sudden currency losses and spread out the costs of extreme losses
over time. Manufacturers and oil importers are likely to be affected by both foreign
currency fluctuations and commodity price changes. They thus would like to hedge
themselves against these risks. Sectors such as horticulture and agriculture are involved
in the import of farm in-puts and export of farm products whose prices are determined
before delivery date. They are therefore also subject to currency fluctuations. It is not
surprising that government departments did not show any interest in this respect, as they
are not in the business of making profits. However, they are also subject to currency
fluctuations when procuring goods and services.

Finally a key hindrance to the growth of the Kenyan currency option market was lack of
guidance by regulators. According to Adeglan (2009), the South African market has
progressed by having a strong regulatory framework that supports the growth of the
currency options market supported by a developed financial market, the same cannot be
said of Kenya from the responses received in the research. The role of the regulator is
discussed in the following section.

5.3.3 Would the existence of currency options thrive in Kenya?

The existence of the currency options market would thrive in Kenya given certain
conditions as all respondents agreed on the usefulness of this market. A majority of the
respondents (81%) saw a role for the regulators in the operations of the options market.
The regulators in this case are the Central Bank of Kenya and the Capital Markets
Authority. Twenty-three percent of the dealers sampled thought lark of regulations
governing the use of currency options hindered the development of the market. This is in
agreement with Alaro (1998) who concluded that the main conditions for an options
market to exist were a growing economy, supported by the Central Bank of Kenya, a
fairly independent exchange rate mechanism, market liquidity and efficiency, a regulatory
organization and a strong and developing banking system. All the above conditions exist
in Kenya to varying degrees with the exception of the regulatory framework.

55
In addition to the regulatory framework knowledge was ranked as one of the factors that
would promote the options market. Dealers who have the knowledge are likely to serve
the clients who ask for this product better than those with no knowledge. A majority of
the dealers surveyed 68.5% had knowledge of currency options markets. Only 38% of the
clients who interacted with the banks were perceived to have average knowledge of
currency options while 31% were perceived to have poor knowledge. Knowledge of the
product would therefore result in a thriving options market.

Risk management has been pointed out as a key area, which would result in the
development of the currency options market, 23% of those surveyed as per Table 4
indicated that growth of the currency option market was dependent on the understanding
of risk inherent in the financial product. As highlighted earlier, the case of Baring bank
and the rouge trader Nick Leason in 1995 cannot be over emphasized (Hull, 1997). This
is the most important experience of derivatives gone wrong in the near past. As such,
bankers need to increase their knowledge of what they are able to accommodate in terms
of risks from options and any other related derivatives. Risk and risk management is one
of the key areas which require to be developed in order to increase the acceptance of
currency options. Risk management goes hand in hand with the development of expertise
within the framework of regulators and financial institutions to improve the ability to
manage currency options.

5.4 Conclusions

5.4.1 Do currency options exist in Kenya?

In Kenya, there is a limited market with few currency options being traded. On average
4.1% of the foreign exchange market, comprise currency options. There is however, a
growing need to grow this market as clients are increasingly asking for currency options
as seen in the 56% rate of inquires in banks for currency options. Inquires were received
from many sectors of the economy with the manufacturing companies forming the
majority. We also conclude that knowledge plays a significant role in the provision of
currency options. However, some players (bank dealers) did not have enough knowledge
to offer options to their clients.

56
5.4.2 Why don’t commercial banks provide options in Kenya?

We can conclude the over the counter currency options market is very relevant in Kenya
today. Most market players would gain value in the use of currency options to hedge
foreign currency exposures. The study also concluded that the Central bank of Kenya and
the Capital Market Authority have a role to play in ensuring options are offered to
customers while offering support to the development of an over the counter currency
option market. The area of legislation and regulation of currency options was seen to be
most urgent.

5.4.3 Would the existence of currency options thrive in Kenya?

The study stated, to improve accessibility to currency options there needs to be demand
for currency options by clients. This should be accompanied by increased product
knowledge and a reduction in the costs associated with currency options. The study
concluded that increased knowledge about currency options by both treasury personnel in
banks and customers would increase the demand for currency options. The need to also
regulate and have legislation associated with currency options was emphasized. Risk
management associated with the use of currency options should be paid attention to. Bank
personnel in association with the regulators staff should monitor the use and accounting
application of currency options, to ensure there is proper risk management by all banks
concerning provision of currency options.

5.5 Recommendations

5.5.1 Recommendations for Improvement

5.5.1.1 Do currency options exist in Kenya?

The currency market in Kenya is still very small, but as the economy expands and
companies continue to grow, they will require more sophisticated hedging techniques like
currency options. There is therefore need to educate business people on the use of
currency options and hedging of foreign exchange exposures.

57
5.5.1.2 Why don’t commercial banks provide options in Kenya?

The study recommends that the market players continue engaging the regulators being the
Central Bank of Kenya and the Capital Markets Authority, to provide them with
regulations and legislations that will govern the currency options market. The regulation
and legislation on currency options will ensure market players are provided with a
framework that will reduce the misuse of currency options and ensure that proper risk
management is undertaken by all parties trading in currency options.

5.5.1.4 Would the existence of currency options thrive in Kenya?

To improve access to currency options in Kenya today the study suggests that the legal
and regulatory framework be improved and at the same time there needs to be increased
training of bank treasury personnel in order to provide them with the necessary skills
associated with currency options.

The study also noted that lack of knowledge from clients in general about currency
options was high. It therefore suggests rigorous marketing of currency options to clients.
The study also noted that reliable sources of data relating to the pricing of currency
options were lacking hence it is recommended that commercial banks set up data banks
on options.

The study also noted that banks need to invest in information technology with computer
systems that would be able to handle foreign exchange risk and other derivatives like
currency options. Such systems would ensure the banks are able to properly manage the
risk associated with options and also profitably offer them to clients in the Kenyan
financial system.

5.5.2 Recommendations for Further Studies

Although this study was conducted extensively and accurately, it surveyed only bank
dealers, and therefore another view from other stakeholders is necessary. We would
therefore suggest further study in the area of currency options in Kenya with a wider
scope that can cover customers and regulators as stakeholders in currency options. This
study laid the foundation by providing a feedback from treasury personnel in commercial

58
banks on their view of the currency option market in Kenya and its growth prospects.
Further studies should pursue similar areas especially as regards to the growth of the
Kenyan financial markets and the dynamism of the Kenyan system in the areas of
derivative products.

59
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Appendix D. E-mail questionnaire

Research letter

Dear Sir/Madam,
I am a student at USIU and am interested in learning about currency options in the
Kenyan Market. My objective is to broaden the pool of knowledge about the use of
currency options in Kenya.

To do this I require to collect data from dealers in commercial banks on the subject. Your
help in the following few questions, which will take a few of your minutes, will make a
real contribution to the accuracy and success of this study.

Your reply will be treated in strict confidence and will be available only to my supervisor
and me. Any publications will only be statistical totals.

Your assistance will be greatly appreciated.

Regards,

Robert Aloo

65
PART 1 GENERAL INFOMRATION
1. Please indicate which of the following best describes your bank.
Multinational bank
Small Local bank
Medium Local bank
Large Local Bank (Please tick one)
2. How long have you been in currency dealing? Please indicate in number of years
(please write period)years 66

PART 2 DO CURRENCY OPTIONS EXIST IN KENYA?

1. Where would you rank your knowledge of currency options as being?

Excellent
Very good
Good
Average
Poor (Please tick one)
2. Does knowledge about options by banks treasury personnel play a part in the provision
of the same to client by commercial banks?
Yes
No (Please tick one)
3. Indicated the percentage of your treasury product offering as a portfolio of your
total products.
Spot 0%
Forwards 0%
Swaps 0%
Options 0%
Futures 0%
Total 100%
4. From which sector of the economy do your get the most requests for currency
options
Manufacturing
Oil Companies
NGO’s

66
 Tourism
Government organizations
Others please specify      
PART 3 WHY DON’T COMMERCIAL BANKS PROVIDE CURRENCY OPTIONS IN
KENYA?

1. What is hindering the emergence of an over-the-counter options market amongst the

Kenyan commercial banks?
Lack of knowledge by dealers of options
Low demand by customers for options
Lack of guidance by the regulator (Central Bank of Kenya, Capital Markets
Authority.
Fear by the banks management of options

2. Do you believe that options would help business people to better manage their
currency exposures?
I strongly agree
I agree
I disagreed
I strongly disagree (Please tick one)

3. Do you think there is adequate knowledge about currency options from the clients
who deal with yourselves at your bank? Please pick from the option list below.
none Excellent knowledge
Poor knowledge
Good knowledge
Average knowledge
Very poor knowledge

4. In your opinion, what percentage of the Kenyan Currency market do options take
up?
0-5%
5-10%

67
 10-15%
15-20% (Please tick one)
5. Do you think the Central Bank of Kenya and the Capital Markets Authority have a
role to play in ensuring options are offered to customers and they develop the same
market?
Yes
No (Please tick one)
Please specify what particular action you would like them to
take___________________________________________________________
PART 3 WOULD THE EXISTENCE OF CURRENCY OPTIONS THRIVE IN
KENYA?

6. Please indicated by order of ranking in your option what hinders the provision of
options to commercial bank clients?
1 being very important to 7 being least important.
Very important 1 2 3 4 5 6 7 least important
Lack of product knowledge 1
Lack of risk appetite by banks 1
High cost of options to client 1
Low demand by clients 1

7. Kindly suggest ways that can be used to improve the provision of options in
Kenya.?
Thank you very much for your time.

Appendix E. Banks to whom questionnaires were administered

1. ABC Bank
2. Barclay's Bank
3. Bank of Africa
4. Bank of Baroda

68
5. Bank of India
6. Chase Bank
7. City Finance Bank
8. CFC-Stanbic Bank
9. Commercial Bank of Africa
10. Consolidated Bank Ltd
11. Cooperative Bank of Kenya
12. Citi-Bank
13. Credit Bank
14. Development Bank
15. Diamond Trust Bank
16. Dubai Bank
17. EcoBank
18. Equity Bank
19. Equatorial Commercial Bank
20. Family Bank
21. Fidelity Bank
22. Fina Bank
23. First Community Bank
24. Giro Commercial Bank
25. Guardian Bank
26. Gulf Bank
27. Habib Bank
28. Habib (AG) Zurich
29. I & M Bank Ltd
30. Imperial Bank
31. Kenya Commercial Bank
32. K-rep Bank
33. Middle East Bank
34. National Bank of Kenya
35. NIC Bank Ltd

69
 36. Oriental Commercial Bank
37. Paramount Bank
38. Prime Bank
39. Southern Credit Bank Ltd.
40. Standard Chartered Bank
41. Trans-National Bank
42. Victoria Commercial Bank
Source: Information on Banks and financial institutions in Kenya.
http://www.centralbank.go.ke/bankinfo/banks.as

70
Appendix F. Graph of Kenya Shilling VS US Dollar

(Source, Reuters)

71