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What can EMU countries' sovereign bond spreads tell us about market perceptions of default probabilities during the recent financial crisis?

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  • Niko Dotz
  • Christoph Fisher
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    Abstract

    This paper presents a new approach to analysing recent movements of EMU sovereign bond spreads. Based on a GARCH-in-mean model originally used in the exchange rate target zone literature, spreads are decomposed into a risk premium, an expected loss component and a liquidity premium. Time-varying probabilities of default are derived. The results suggest that the rise in sovereign spreads during the recent financial crisis mainly reflects an increased expected loss component. In addition, the rescue of Bear Stearns in March 2008 seems to mark a change in market perceptions of sovereign bond risk. The government bonds of some countries lost their former role as a safe haven. While price competitiveness always helps to explain sovereign spreads, it increasingly moved into investors’ focus as financial sector soundness weakened.

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    File URL: http://www.dallasfed.org/assets/documents/institute/wpapers/2011/0069.pdf
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    Bibliographic Info

    Paper provided by Federal Reserve Bank of Dallas in its series Globalization and Monetary Policy Institute Working Paper with number 69.

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    Date of creation: 2011
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    Handle: RePEc:fip:feddgw:69

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    Keywords: Liquidity (Economics) ; Default (Finance) ; Bonds - Prices;

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    1. Morris Goldstein & Philip Turner, 2004. "Controlling Currency Mismatches in Emerging Markets," Peterson Institute Press: All Books, Peterson Institute for International Economics, number 373.
    2. Simone Manganelli & Guido Wolswijk, 2009. "What drives spreads in the euro area government bond market?," Economic Policy, CEPR & CES & MSH, vol. 24, pages 191-240, 04.
    3. 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.
    4. Carmen M. Reinhart & Kenneth S. Rogoff & Miguel A. Savastano, 2003. "Debt Intolerance," NBER Working Papers 9908, National Bureau of Economic Research, Inc.
      • Reinhart, Carmen & Rogoff, Kenneth & Savastano, Miguel, 2003. "Debt intolerance," MPRA Paper 13932, University Library of Munich, Germany.
    5. Barry Eichengreen & Ricardo Hausmann & Ugo Panizza, 2003. "Currency Mismatches, Debt Intolerance and Original Sin: Why They Are Not the Same and Why it Matters," NBER Working Papers 10036, National Bureau of Economic Research, Inc.
    6. Edda Zoli & Silvia Sgherri, 2009. "Euro Area Sovereign Risk During the Crisis," IMF Working Papers 09/222, International Monetary Fund.
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    Cited by:
    1. Groba, Jonatan & Lafuente, Juan A. & Serrano, Pedro, 2013. "The impact of distressed economies on the EU sovereign market," Journal of Banking & Finance, Elsevier, vol. 37(7), pages 2520-2532.

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