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Market perception of fiscal sustainability: An application to the largest euro area economies

  • Maximiano Pinheiro

Debt intolerance may rule out fiscal trajectories which otherwise appear to be sustainable. If fiscal policy lacks credibility, the interest on the sovereign debt may rise sharply and the country may lose market access. Indicators for assessing the market perception of fiscal sustainability should complement the conventional empirical sustainability analysis. I propose an approach for extracting information from sovereign bond data, which provides snapshots of market sentiment. It is based on a multi-borrower default-intensity pricing model, allowing for the cross-section estimation (under a risk-neutral probability measure) of the term-structure of the unobservable default-free interest rates, as well as (for all sovereigns included in the sample) of the probabilities of default (for any horizon deemed relevant) and the associated recovery rates given default. The approach is illustrated by the estimation of the model for Germany, France, Italy and Spain for every Friday from October 2, 2009 to November 25, 2011.

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Paper provided by Banco de Portugal, Economics and Research Department in its series Working Papers with number w201209.

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Date of creation: 2012
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Handle: RePEc:ptu:wpaper:w201209
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  1. Wilcox, David W, 1989. "The Sustainability of Government Deficits: Implications of the Present-Value Borrowing Constraint," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 21(3), pages 291-306, August.
  2. Jarrow, Robert A & Turnbull, Stuart M, 1995. " Pricing Derivatives on Financial Securities Subject to Credit Risk," Journal of Finance, American Finance Association, vol. 50(1), pages 53-85, March.
  3. Reinhart, Carmen & Rogoff, Kenneth & Savastano, Miguel, 2003. "Debt intolerance," MPRA Paper 13932, University Library of Munich, Germany.
  4. Jun Pan & Kenneth J. Singleton, 2008. "Default and Recovery Implicit in the Term Structure of Sovereign "CDS" Spreads," Journal of Finance, American Finance Association, vol. 63(5), pages 2345-2384, October.
  5. Haug, Alfred A, 1991. "Cointegration and Government Borrowing Constraints: Evidence for the United States," Journal of Business & Economic Statistics, American Statistical Association, vol. 9(1), pages 97-101, January.
  6. Bharat Trehan & Carl E. Walsh, 1988. "Testing intertemporal budget constraints: theory and applications to U. S. federal budget and current account deficits," Working Papers in Applied Economic Theory 88-03, Federal Reserve Bank of San Francisco.
  7. Harrison, J. Michael & Kreps, David M., 1979. "Martingales and arbitrage in multiperiod securities markets," Journal of Economic Theory, Elsevier, vol. 20(3), pages 381-408, June.
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