What can EMU countries' sovereign bond spreads tell us about market perceptions of default probabilities during the recent financial crisis?
AbstractThis 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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Bibliographic InfoPaper provided by Federal Reserve Bank of Dallas in its series Globalization and Monetary Policy Institute Working Paper with number 69.
Date of creation: 2011
Date of revision:
This paper has been announced in the following NEP Reports:
- NEP-ALL-2011-02-05 (All new papers)
- NEP-EEC-2011-02-05 (European Economics)
- NEP-IFN-2011-02-05 (International Finance)
- NEP-RMG-2011-02-05 (Risk Management)
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