Uncovering the Common Risk Free Rate in the European Monetary Union

Rien Wagenvoort () and Sanne Zwart ()
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Rien Wagenvoort: European Investment Bank, Economic and Financial Studies
Sanne Zwart: European Investment Bank, Economic and Financial Studies

No 2010/5, Economic and Financial Reports from European Investment Bank, Economics Department

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.

Keywords: Factor analysis; risk free interest rate; sovereign bond; benchmark (search for similar items in EconPapers)
JEL-codes: C19 E43 G12 (search for similar items in EconPapers)
Pages: 47 pages
Date: 2010-09-01
New Economics Papers: this item is included in nep-eec and nep-mon
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Persistent link: https://EconPapers.repec.org/RePEc:ris:eibefr:2010_005

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