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UNCOVERING THE COMMON RISK‐FREE RATE IN THE EUROPEAN MONETARY UNION
Author(s) -
Wagenvoort Rien J. L. M.,
Zwart Sanne
Publication year - 2013
Publication title -
journal of applied econometrics
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 2.878
H-Index - 99
eISSN - 1099-1255
pISSN - 0883-7252
DOI - 10.1002/jae.2335
Subject(s) - bond , market liquidity , economics , credit risk , monetary economics , dimension (graph theory) , european union , liquidity premium , risk premium , financial economics , liquidity risk , econometrics , actuarial science , international economics , finance , mathematics , pure mathematics
SUMMARY We introduce longitudinal factor analysis (LFA) to extract the common risk‐free (CRF) rate from a sample of sovereign bonds of countries in a monetary union. Since LFA exploits the typically very large longitudinal dimension of bond data, it performs better than traditional factor analysis methods that rely on the much smaller cross‐sectional dimension. European sovereign bond yields for the period 2006–2011 are decomposed into a CRF rate, a default risk premium and a liquidity risk premium. Our empirical findings suggest that investors chase both credit quality and liquidity, and that they price double default risk on credit default swaps. Copyright © 2013 John Wiley & Sons, Ltd.