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Sovereign spreads in the eurozone: which prospects for a Eurobond?
[Asset pricing with liquidity risk]

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  • Carlo Favero
  • Alessandro Missale

Abstract

In this paper, we provide new evidence on the determinants of sovereign yield spreads and ‘market sentiment’ effects in the eurozone in order to evaluate the rationale for a common Eurobond jointly guaranteed by eurozone Member States. We find that default risk is the main driver of yield spreads, suggesting small gains from greater liquidity. Fiscal fundamentals matter in the pricing of default risk but only as they interact with other countries’ yield spreads; that is, with the global risk that the market perceives. More importantly, the impact of this global risk variable is not constant over time, a clear sign of contagion driven by shifts in market sentiment. This evidence points to a discontinuity in the disciplinary role of financial markets. If markets can stay irrational longer than a country can stay solvent, then the role of yield spreads on national bonds as a fiscal discipline device is considerably weakened, and issuing Eurobonds can be economically justified.— Carlo Favero and Alessandro Missale

Suggested Citation

  • Carlo Favero & Alessandro Missale, 2012. "Sovereign spreads in the eurozone: which prospects for a Eurobond? [Asset pricing with liquidity risk]," Economic Policy, CEPR, CESifo, Sciences Po;CES;MSH, vol. 27(70), pages 231-273.
    • Handle: RePEc:oup:ecpoli:v:27:y:2012:i:70:p:231-273.
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    File URL: http://hdl.handle.net/10.1111/j.1468-0327.2012.00282.x
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