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What are the driving factors behind the rise of spreads and CDS of euro-area sovereign bonds? A FAVAR model for Greece and Ireland

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  • Nicholas Apergis
  • Emmanuel Mamatzakis

Abstract

This paper examines the dynamics of selected euro-area sovereign bonds by employing a factor augmenting vector autoregressive (FAVAR) model for the first time in the literature. This methodology identifies the underlying transmission mechanisms of several factors, and in particular, market liquidity and credit risk. Departing from the classical vector autoregressive (VAR) models allows us to relax limitations regarding the choice of variables that could drive spreads and CDS of euro-area sovereign debts. The results show that liquidity, credit risk and flight to quality drive both spreads and CDS of five years maturity over swaps for Greece and Ireland in recent years. Greece, in particular, is facing an elastic demand for its sovereign bonds that further stretches liquidity. Moreover, in illiquid debt markets spreads continue to follow a steep upward trend which is expected to have certain adverse implications for financial stability. We also observe a negative feedback effect from counterparty credit risk.

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Bibliographic Info

Article provided by Inderscience Enterprises Ltd in its journal Int. J. of Economics and Business Research.

Volume (Year): 7 (2014)
Issue (Month): 1 ()
Pages: 104-120

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Handle: RePEc:ids:ijecbr:v:7:y:2014:i:1:p:104-120

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Web page: http://www.inderscience.com/browse/index.php?journalID==310

Related research

Keywords: sovereign debt crisis; spreads; credit default swap; CDS; FAVAR model; Greece; Ireland; Euro Zone; sovereign bonds; factor augmenting vector autoregressive; market liquidity; credit risk.;

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  1. Juan Ignacio Pena & Santiago Forte, 2006. "CREDIT SPREADS: THEORY AND EVIDENCE ABOUT THE INFORMATION CONTENT OF STOCKS, BONDS AND CDSs," Business Economics Working Papers wb063310, Universidad Carlos III, Departamento de Economía de la Empresa.
  2. Jarrow, Robert A & Turnbull, Stuart M, 1995. " Pricing Derivatives on Financial Securities Subject to Credit Risk," Journal of Finance, American Finance Association, vol. 50(1), pages 53-85, March.
  3. Houweling, P. & Vorst, A.C.F., 2002. "An Empirical Comparison of Default Swap Pricing Models," ERIM Report Series Research in Management ERS-2002-23-F&A, Erasmus Research Institute of Management (ERIM), ERIM is the joint research institute of the Rotterdam School of Management, Erasmus University and the Erasmus School of Economics (ESE) at Erasmus Uni.
  4. Jarrow, Robert A & Lando, David & Turnbull, Stuart M, 1997. "A Markov Model for the Term Structure of Credit Risk Spreads," Review of Financial Studies, Society for Financial Studies, vol. 10(2), pages 481-523.
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