A joint non-parametric approach to the decomposition of bond yields and CDS spreads: application of Eurozone market data

Victor Lapshin and Marat Kurbangaleev

HSE Working papers from National Research University Higher School of Economics

Abstract: In this paper we develop a joint non-parametric approach to the problem of the decomposition of bond yields and CDS spreads. The proposed approach is essentially an infinite-dimensional modification of the Heath-Jarrow-Morton framework and is general enough to capture even very non-trivial shapes of the yield and hazard-rate curves. The approach allows us to jointly estimate entire term structures of yields, hazard rates, and liquidity premiums, no matter what shapes they take. We apply the developed methodology to data on major Eurozone sovereign borrowers and consider the most recent period of the Eurozone debt crisis. Our data set includes instruments with maturities from 6 months to 30 years. As a result, we found several interesting interaction effects between those components in terms of term structure. Treating the bond-CDS basis as a measure of the cross-market liquidity spread, we find that cross-market liquidity evolves in a rather non-trivial and pronounced manner. As the credit quality of the reference entity deteriorates, the liquidity of the CDS market dries up, starting from longer terms.

Keywords: term structure; interest rates; credit risk; default intensity; liquidity premium; bond; credit default swap; risk premium. (search for similar items in EconPapers)
JEL-codes: C14 G12 (search for similar items in EconPapers)
Pages: 20 pages
Date: 2013
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Published in WP BRP Series: Financial Economics / FE, March 2013, pages 1-20

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Persistent link: https://EconPapers.repec.org/RePEc:hig:wpaper:13/fe/2013

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