Fiscal Sustainability, Default Risk and Euro Area Sovereign Bond Spreads
Banque de France
Goethe University Frankfurt
Banque de France -DGEI-DEMFI-RECFIN
Banque de France
October 12, 2011
Paris December 2011 Finance Meeting EUROFIDAI - AFFI
This paper develops an arbitrage-free affine term structure model of potentially defaultable sovereign bonds to model a cross-section of eight euro area government bond yield curves since January 1999. The existence of a common monetary policy under European Monetary Union determines the short end of the yield curves, whereas decentralized debt policies drive expected default probabilities and thereby spreads towards Germany, assumed to be free of default risk. The pricing factors are three observable area-wide macroeconomic variables and measures of national fiscal sustainability, which we proxy by expected changes in debt/GDP ratios of the respective countries. Our model explains spreads both before and during the crisis to an impressive extent. The deterioration in public finances was the major driver of the widening in spreads since 2008 through both heightened compensations for default risk and increases in risk premia. We also present perceived probabilities of sovereign default at any maturity and assess their elasticity to shifts in expected changes in debt/GDP ratios.
Number of Pages in PDF File: 57
Keywords: Government debt, affine term structure models, default risk, yield spreads, fiscal projections
JEL Classification: C32, E6, H6, G12working papers series
Date posted: October 13, 2011 ; Last revised: November 3, 2011
© 2013 Social Science Electronic Publishing, Inc. All Rights Reserved.
This page was processed by apollo8 in 0.328 seconds