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Credit and Liquidity Risks in Euro-area Sovereign Yield Curves

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  • Alain Monfort

    ()
    (CREST, University of Maastricht)

  • Jean-Paul Renne

    (Banque de France)

Abstract

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.

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Bibliographic Info

Paper provided by Centre de Recherche en Economie et Statistique in its series Working Papers with number 2011-26.

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Length: 43
Date of creation: Jul 2011
Date of revision:
Handle: RePEc:crs:wpaper:2011-26

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Keywords: default risk; liquidity risk; term structure of interest rates; regime switching; euro-area spreads;

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References

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Cited by:
  1. Badaoui, Saad & Cathcart, Lara & El-Jahel, Lina, 2013. "Do sovereign credit default swaps represent a clean measure of sovereign default risk? A factor model approach," Journal of Banking & Finance, Elsevier, vol. 37(7), pages 2392-2407.
  2. Borgy, V. & Laubach, T. & Mésonnier, J-S. & Renne, J-P., 2011. "Fiscal Sustainability, Default Risk and Euro Area Sovereign Bond Spreads Markets," Working papers 350, Banque de France.

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