Uncovering the Common Risk‐free Rate in the European Monetary Union

Abstract

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Decomposing Euro Area Sovereign Spreads: Credit, Liquidity and Convenience

“…First of all, we note that the sovereign spread, that is, the di¤erence between the zerocoupon and the OIS 10-year rates, is on average positive also for Germany, contrary to the widespread belief that German yields can be used as proxies for risk-free rates. The dynamics of the German spread (Figure 1), as computed in this paper, are similar to those estimated by Wagenvoort and Zwart (2014), who propose a new factor analysis technique to extract the risk-free rate -a latent variable in their model -from a panel of euro area sovereign bond yields; their measure of the German sovereign spread, like ours, has been on average positive since the beginning of 2009.…”

“…To compare their results with ours and with others reported in the literature, we note that they estimate that the liquidity premium is on average 45 basis points out of 168 (for Italy, on the 5-year maturity). Wagenvoort and Zwart (2014) also analyze the sovereign yields of a number of euro area countries in a period (from February 2006 to December 2011) that overlaps with the period of the sovereign crisis. They set up a factor model where risk-free rates, credit premia and liquidity premia are latent and they propose a novel technique (called Longitudinal Factor Analysis) to estimate these latent factors.…”

“…Both Monfort and Renne (2014) and Wagenvoort and Zwart (2014) use latent variable models. The fact that they reach very di¤erent conclusions about the magnitude of liquidity premia suggests that the results from their class of models might be sensitive to the assumptions made in order to identify the premia.…”