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Uncovering the Common Risk Free Rate in the European Monetary Union

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  • Wagenvoort, Rien

    ()
    (European Investment Bank, Economic and Financial Studies)

  • Zwart, Sanne

    ()
    (European Investment Bank, Economic and Financial Studies)

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    Abstract

    We introduce Longitudinal Factor Analysis (LFA) to extract the Common Risk Free (CRF)rate from a sample of sovereign bonds of countries in a monetary union. Since LFA exploits the typically very large longitudinal dimension of bond data, it performs better than traditional factor analysis methods that rely on the much smaller cross-sectional dimension. European sovereign bond yields for the period 2006-2010 are decomposed into a CRF rate, a default risk premium, and a liquidity risk premium, shedding new light on issues such as benchmark status, flight-to-quality and flight-to-liquidity hypotheses. Our empirical findings suggest that investors chase both credit quality and liquidity, and that liquidity is more valued when aggregate risk is high.

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    Bibliographic Info

    Paper provided by European Investment Bank, Economics Department in its series Economic and Financial Reports with number 2010/5.

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    Length: 47 pages
    Date of creation: 01 Sep 2010
    Date of revision:
    Handle: RePEc:ris:eibefr:2010_005

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    Keywords: Factor analysis; risk free interest rate; sovereign bond; benchmark;

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