The Term Structure of Interest Rates in a Heterogeneous Monetary Union

66 Pages Posted: 25 Jul 2022

See all articles by James S. Costain

James S. Costain

Banco de España - Research Department

Galo Nuño

Banco de España

Carlos Thomas

Banco de España

Date Written: 2022

Abstract

We build a no-arbitrage model of the yield curves in a heterogeneous monetary union with sovereign default risk, which can account for the asymmetric shifts in euro area yields during the Covid-19 pandemic. We derive an affine term structure solution, and decompose yields into term premium and credit risk components. In an extension, we endogenize the peripheral default probability, showing that it decreases with central bank bond-holdings. Calibrating the model to Germany and Italy, we show that a “default risk extraction” channel is the main driver of Italian yields, and that flexibility makes asset purchases more effective.

Keywords: sovereign default, quantitative easing, yield curve, affine model, Covid-19 crisis, ECB, pandemic emergency purchase programme

JEL Classification: E500, G120, F450

Suggested Citation

Costain, James S. and Nuno, Galo and Thomas, Carlos, The Term Structure of Interest Rates in a Heterogeneous Monetary Union (2022). CESifo Working Paper No. 9844, Available at SSRN: https://ssrn.com/abstract=4169378 or http://dx.doi.org/10.2139/ssrn.4169378

James S. Costain (Contact Author)

Banco de España - Research Department ( email )

Alcala 50
28014 Madrid
Spain

Galo Nuno

Banco de España ( email )

Alcala 50
Madrid 28014
Spain

Carlos Thomas

Banco de España ( email )

Alcala 50
Madrid 28014
Spain

HOME PAGE: http://www.bde.es

Do you have negative results from your research you’d like to share?

Paper statistics

Downloads
66
Abstract Views
283
Rank
224,198
PlumX Metrics