Uncovering the Common Risk Free Rate in the European Monetary Union
AbstractWe 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 InfoPaper provided by European Investment Bank, Economics Department in its series Economic and Financial Reports with number 2010/5.
Length: 47 pages
Date of creation: 01 Sep 2010
Date of revision:
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Factor analysis; risk free interest rate; sovereign bond; benchmark;
Find related papers by JEL classification:
- C19 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Other
- E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
This paper has been announced in the following NEP Reports:
- NEP-ALL-2010-10-09 (All new papers)
- NEP-EEC-2010-10-09 (European Economics)
- NEP-MON-2010-10-09 (Monetary Economics)
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