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Uncovering the Common Risk Free Rate in the European Monetary Union

Author

Listed:
  • Wagenvoort, Rien

    (European Investment Bank, Economic and Financial Studies)

  • Zwart, Sanne

    (European Investment Bank, Economic and Financial Studies)

Abstract

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 2006-2010 are decomposed into a CRF rate, a default risk premium, and a liquidity risk premium, shedding new light on issues such as benchmark status, flight-to-quality and flight-to-liquidity hypotheses. Our empirical findings suggest that investors chase both credit quality and liquidity, and that liquidity is more valued when aggregate risk is high.

Suggested Citation

  • Wagenvoort, Rien & Zwart, Sanne, 2010. "Uncovering the Common Risk Free Rate in the European Monetary Union," Economic and Financial Reports 2010/5, European Investment Bank, Economics Department.
    • Handle: RePEc:ris:eibefr:2010_005
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    More about this item

    Keywords

    Factor analysis; risk free interest rate; sovereign bond; benchmark;
    All these keywords.

    JEL classification:

    • C19 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Other
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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