Are European Sovereign Bonds Fairly Priced? The Role of Modeling Uncertainty

58 Pages Posted: 7 Nov 2013

See all articles by Leo de Haan

Leo de Haan

De Nederlandsche Bank

Jeroen Hessel

De Nederlandsche Bank

Jan Willem van den End

De Nederlandsche Bank

Date Written: November 6, 2013

Abstract

This paper examines the extent to which large swings of sovereign yields in euro area countries during the sovereign debt crisis can be attributed to fundamentals. We focus on the inherent uncertainty in bond yield models, which is often overlooked in the literature. We show that the outcomes are strongly affected by modeling choices with regard to i) the confidence bands for the model prediction, ii) the assumption whether the model coefficients are similar across countries or not, iii) the sample selection, iv) the inclusion of financial variables and v) the choice of time-varying coefficients. These choices affect the explanatory power of macro fundamentals and the extent of mispricing. We find substantial misalignment compared to fundamentals for Greek yields, in most specifications also for Portugal and Ireland, but for the other EMU countries, including Spain and Italy, the evidence is less clear cut. This calls for modesty in interpreting bond yield models and for cautiousness when using them in policymaking.

Keywords: Sovereign bond, Interest rate, Risk premium

JEL Classification: E43, E44, F34, G15

Suggested Citation

de Haan, Leo and Hessel, Jeroen and van den End, Jan Willem, Are European Sovereign Bonds Fairly Priced? The Role of Modeling Uncertainty (November 6, 2013). De Nederlandsche Bank Working Paper No. 399. Available at SSRN: https://ssrn.com/abstract=2350766 or http://dx.doi.org/10.2139/ssrn.2350766

Leo de Haan (Contact Author)

De Nederlandsche Bank ( email )

P.O. Box 98
1000 AB Amsterdam
Netherlands
+31 20 5243539 (Phone)
+31 20 5242514 (Fax)

Jeroen Hessel

De Nederlandsche Bank ( email )

PO Box 98
1000 AB Amsterdam
Amsterdam, 1000 AB
Netherlands

Jan Willem van den End

De Nederlandsche Bank ( email )

PO Box 98
1000 AB Amsterdam
Amsterdam, 1000 AB
Netherlands

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