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Uncovering The Common Risk‐Free Rate In The European Monetary Union

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  • Rien J. L. M. Wagenvoort
  • Sanne Zwart

Abstract

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.

Suggested Citation

  • Rien J. L. M. Wagenvoort & Sanne Zwart, 2014. "Uncovering The Common Risk‐Free Rate In The European Monetary Union," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 29(3), pages 394-414, April.
    • Handle: RePEc:wly:japmet:v:29:y:2014:i:3:p:394-414
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    Cited by:

    1. Marcello Pericoli & Marco Taboga, 2015. "Decomposing euro area sovereign spreads: credit, liquidity and convenience," Temi di discussione (Economic working papers) 1021, Bank of Italy, Economic Research and International Relations Area.

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