Fiscal Sustainability, Default Risk and Euro Area Sovereign Bond Spreads Markets
AbstractThis 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.
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Bibliographic InfoPaper provided by Banque de France in its series Working papers with number 350.
Length: 61 pages
Date of creation: 2011
Date of revision:
Government debt; affine term structure models; default risk; yield spreads; fiscal projections.;
Find related papers by JEL classification:
- C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
- E6 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
- H6 - Public Economics - - National Budget, Deficit, and Debt
This paper has been announced in the following NEP Reports:
- NEP-ALL-2011-11-14 (All new papers)
- NEP-CBA-2011-11-14 (Central Banking)
- NEP-EEC-2011-11-14 (European Economics)
- NEP-FMK-2011-11-14 (Financial Markets)
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