Modeling and Pricing Exotic Options in Frontier Markets: A Computational Approach with Applications to Kenya’s Financial Sector
DOI:
https://doi.org/10.47604/ijfa.3399Keywords:
Exotic Options, Financial Modeling, Monte Carlo Simulation, Option Pricing, Frontier Markets, Derivatives, Market Microstructure, Computational FinanceAbstract
Purpose: This research examines how exotic options—such as Asian, lookback, and barrier options—are priced in Kenya’s emerging financial market. It looks into whether sophisticated computational models can work effectively in a market challenged by limited data, low liquidity, and underdeveloped infrastructure. The study addresses a gap in existing literature, which mostly focuses on well-established markets, by assessing the feasibility of introducing complex financial instruments in frontier economies to encourage innovation, better risk management, and economic growth.
Methodology: The study uses a quantitative approach, combining stochastic models with real market data from the Nairobi Securities Exchange (NSE) collected between 2019 and 2023. It also incorporates recent guidelines from the Capital Markets Authority (CMA). Pricing methods such as Monte Carlo simulations, Finite Difference Methods (FDM), and binomial/trinomial tree models are tailored to fit the local market context. To overcome the challenges of limited data, techniques like kernel smoothing for volatility estimation and bootstrapping to create synthetic data sets are applied. A mix of these methods helps improve pricing accuracy, especially under conditions of incomplete information and clustered volatility.
Findings: The Monte Carlo method proves highly effective for pricing options that depend on the path of the underlying asset, while FDM, especially the Crank-Nicolson approach, handles early exercise options and price jumps well. Binomial and trinomial trees remain reliable in data-scarce environments. Despite infrastructural and regulatory hurdles, the study shows that calibrating pricing models is possible using resampling and non-parametric methods. The results highlight the potential benefits of exotic derivatives in managing risks within key sectors such as agriculture, energy, and trade.
Unique Contribution to Theory, Practice and Theory: This work enhances the theoretical framework by adjusting traditional option pricing models to fit the challenges of frontier markets. It provides a practical toolkit for financial firms and offers regulatory recommendations to nurture a sustainable derivatives market. By aligning advanced modeling techniques with local market realities, the study paves the way for broader adoption of derivative products in underdeveloped financial systems.
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