Credit and Liquidity Risks in Euro Area Sovereign Yield Curves
National Institute of Statistics and Economic Studies (INSEE) - Center for Research in Economics and Statistics (CREST); National Bureau of Economic Research (NBER); Maastricht University
Banque de France
November 1, 2011
Banque de France Working Paper No. 352
In this paper, we propose a model of the joint dynamics of euro-area sovereign yield curves. The arbitrage-free valuation framework involves five factors and two regimes, one of the latter being interpreted as a crisis regime. These common factors and regimes explain most of the fluctuations in euro-area yields and spreads. The regime-switching feature of the model turns out to be particularly relevant to capture the rise in volatility experienced by fixed-income markets over the last years. In our reduced-form set up, each country is characterized by a hazard rate, specified as some linear combinations of the factors and regimes. The hazard rates incorporate both liquidity and credit components, that we aim at disentangling. The estimation suggests that a substantial share of the changes in euro-area yield differentials is liquidity-driven. Our approach is consistent with the fact that sovereign default risk is not diversifiable, which gives rise to specific risk premia that are incorporated in spreads. Once liquidity-pricing effects and risk premia are filtered out of the spreads, we obtain estimates of the actual – or real-world – default probabilities. The latter turn out to be significantly lower than their risk-neutral counterparts.
Number of Pages in PDF File: 46
Keywords: default risk, liquidity risk, term structure of interest rates, regime-switching, euro-area spreads
JEL Classification: E43, E44, E47, G12, G24working papers series
Date posted: November 29, 2011
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