The Term Structure of Interest Rates in a Heterogeneous Monetary Union

James Costain, Galo Nuño Barrau and Carlos Thomas

Journal of Finance, 2025, vol. 80, issue 4, 2389-2434

Abstract: We build an arbitrage‐based model of the yield curves in a heterogeneous monetary union with sovereign default risk, which accounts for the asymmetric shifts in euro‐area yields during the Covid‐19 pandemic. We derive an affine term structure solution, and decompose yields into expectations, term premium, expected default loss, and credit risk premium components. In an extension, we endogenize the peripheral default probability, showing that it decreases with central bank bond holdings. Calibrating the model to Germany and Italy, we show that both the level and the shifts in the sovereign spread are mainly attributable to the credit risk premium.

Date: 2025
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https://doi.org/10.1111/jofi.13463

Related works:
Working Paper: The term structure of interest rates in a heterogeneous monetary union (2024)
Working Paper: The Term Structure of Interest Rates in a Heterogeneous Monetary Union (2024)
Working Paper: The Term Structure of Interest Rates in a Heterogeneous Monetary Union (2022)
Working Paper: The Term Structure of Interest Rates in a Heterogeneous Monetary Union (2022)
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