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A joint non-parametric approach to the decomposition of bond yields and CDS spreads: application of Eurozone market data

  • Victor Lapshin

    ()

    (National Research University Higher School of Economics. Financial Engineering and Risk Management Laboratory)

  • Marat Kurbangaleev

    ()

    (National Research University Higher School of Economics. Financial Engineering and Risk Management Laboratory)

In this paper we develop a joint non-parametric approach to the problem of the decomposition of bond yields and CDS spreads. The proposed approach is essentially an infinite-dimensional modification of the Heath-Jarrow-Morton framework and is general enough to capture even very non-trivial shapes of the yield and hazard-rate curves. The approach allows us to jointly estimate entire term structures of yields, hazard rates, and liquidity premiums, no matter what shapes they take. We apply the developed methodology to data on major Eurozone sovereign borrowers and consider the most recent period of the Eurozone debt crisis. Our data set includes instruments with maturities from 6 months to 30 years. As a result, we found several interesting interaction effects between those components in terms of term structure. Treating the bond-CDS basis as a measure of the cross-market liquidity spread, we find that cross-market liquidity evolves in a rather non-trivial and pronounced manner. As the credit quality of the reference entity deteriorates, the liquidity of the CDS market dries up, starting from longer terms.

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Paper provided by National Research University Higher School of Economics in its series HSE Working papers with number WP BRP 13/FE/2013.

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Length: 20 pages
Date of creation: 2013
Date of revision:
Publication status: Published in WP BRP Series: Financial Economics / FE, March 2013, pages 1-20
Handle: RePEc:hig:wpaper:13/fe/2013
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  1. Tomas Björk & Bent Jesper Christensen, 1999. "Interest Rate Dynamics and Consistent Forward Rate Curves," Mathematical Finance, Wiley Blackwell, vol. 9(4), pages 323-348.
  2. Longstaff, Francis A. & Santa-Clara, Pedro & Schwartz, Eduardo S., 2001. "Throwing away a billion dollars: the cost of suboptimal exercise strategies in the swaptions market," Journal of Financial Economics, Elsevier, vol. 62(1), pages 39-66, October.
  3. Francis A. Longstaff & Sanjay Mithal & Eric Neis, 2005. "Corporate Yield Spreads: Default Risk or Liquidity? New Evidence from the Credit Default Swap Market," Journal of Finance, American Finance Association, vol. 60(5), pages 2213-2253, October.
  4. Bühler, Wolfgang & Trapp, Monika, 2009. "Time-varying credit risk and liquidity premia in bond and CDS markets," CFR Working Papers 09-13, University of Cologne, Centre for Financial Research (CFR).
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