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Credit and liquidity risks in euro area sovereign yield curves

Alain Monfort () and Jean-Paul Renne

Working papers from Banque de France

Abstract: In this paper, we propose a model of the joint dynamics of euro-area sovereign yield curves. The arbitrage-free valuation framework involves five factors and two regimes, one of the latter being interpreted as a crisis regime. These common factors and regimes explain most of the fluctuations in euro-area yields and spreads. The regime-switching feature of the model turns out to be particularly relevant to capture the rise in volatility experienced by fixed-income markets over the last years. In our reduced-form set up, each country is characterized by a hazard rate, specified as some linear combinations of the factors and regimes. The hazard rates incorporate both liquidity and credit components, that we aim at disentangling. The estimation suggests that a substantial share of the changes in euro-area yield differentials is liquidity-driven. Our approach is consistent with the fact that sovereign default risk is not diversifiable, which gives rise to specific risk premia that are incorporated in spreads. Once liquidity-pricing effects and risk premia are filtered out of the spreads, we obtain estimates of the actual –or real-world– default probabilities. The latter turn out to be significantly lower than their risk-neutral counterparts.

Keywords: default risk; liquidity risk; term structure of interest rates; regime-switching; euro-area spreads. (search for similar items in EconPapers)
JEL-codes: E43 E44 E47 G12 G24 (search for similar items in EconPapers)
Pages: 46 pages
Date: 2011
New Economics Papers: this item is included in nep-ban, nep-cba, nep-eec, nep-ias and nep-mac
References: View references in EconPapers View complete reference list from CitEc
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Working Paper: Credit and Liquidity Risks in Euro-area Sovereign Yield Curves (2011) Downloads
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Persistent link: https://EconPapers.repec.org/RePEc:bfr:banfra:352

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