Decomposing Euro-area sovereign spreads: Credit and liquidity risks

A.M.E. Monfort, J.-P. Renne

Research output: Contribution to journalArticleAcademicpeer-review

Abstract

This article presents an intensity-based model of euro-area sovereign spreads. To identify liquidity-pricing effects, we exploit the information contained in the spreads between bonds issued by a German agency (KfW) and their sovereign counterparts. KfW's liabilities being guaranteed by the German government, these spreads are essentially liquidity-driven. Liquidity effects are found to account for a sizeable share of spreads' fluctuations. After having filtered risk premiums out of the spreads, we estimate the physical default probabilities of eleven countries. Physical probabilities of default are lower than risk-neutral ones, consistently with the existence of a nondiversifiable euro-area sovereign credit risk.
Original languageEnglish
Pages (from-to)2103-2151
JournalReview of Finance
Volume18
Issue number6
DOIs
Publication statusPublished - 1 Jan 2014

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