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Are European sovereign bonds fairly priced? The role of modeling uncertainty

Leo de Haan (), Jeroen Hessel () and Jan Willem End ()

DNB Working Papers from Netherlands Central Bank, Research Department

Abstract: This paper examines the extent to which large swings of sovereign yields in euro area countries during the sovereign debt crisis can be attributed to fundamentals. We focus on the inherent uncertainty in bond yield models, which is often overlooked in the literature. We show that the outcomes are strongly affected by modeling choices with regard to i) the confidence bands for the model prediction, ii) the assumption whether the model coefficients are similar across countries or not, iii) the sample selection, iv) the inclusion of financial variables and v) the choice of time-varying coefficients. These choices affect the explanatory power of macro fundamentals and the extent of mispricing. We find substantial misalignment compared to fundamentals for Greek yields, in most specifications also for Portugal and Ireland, but for the other EMU countries, including Spain and Italy, the evidence is less clear cut. This calls for modesty in interpreting bond yield models and for cautiousness when using them in policymaking.

Keywords: Sovereign bond; Interest rate; Risk premium (search for similar items in EconPapers)
JEL-codes: E43 E44 F34 G15 (search for similar items in EconPapers)
Date: 2013-10
New Economics Papers: this item is included in nep-fmk, nep-mac and nep-opm
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Journal Article: Are European sovereign bonds fairly priced? The role of modelling uncertainty (2014) Downloads
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Persistent link: https://EconPapers.repec.org/RePEc:dnb:dnbwpp:399

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