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Decomposing Euro-Area Sovereign Spreads: Credit and Liquidity Risks

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  • Alain Monfort
  • Jean-Paul Renne

Abstract

This article presents an intensity-based model of euro-area sovereign spreads. To identify liquidity-pricing effects, we exploit the information contained in the spreads between bonds issued by a German agency (KfW) and their sovereign counterparts. KfW’s liabilities being guaranteed by the German government, these spreads are essentially liquidity-driven. Liquidity effects are found to account for a sizeable share of spreads’ fluctuations. After having filtered risk premiums out of the spreads, we estimate the physical default probabilities of eleven countries. Physical probabilities of default are lower than risk-neutral ones, consistently with the existence of a nondiversifiable euro-area sovereign credit risk.

Suggested Citation

  • Alain Monfort & Jean-Paul Renne, 2014. "Decomposing Euro-Area Sovereign Spreads: Credit and Liquidity Risks," Review of Finance, European Finance Association, vol. 18(6), pages 2103-2151.
    • Handle: RePEc:oup:revfin:v:18:y:2014:i:6:p:2103-2151.
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    File URL: http://hdl.handle.net/10.1093/rof/rft049
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