Decomposing euro-area sovereign spreads : credit and liquidity risks ∗

This paper presents an arbitrage-free model of the joint dynamics of euro-area sovereign bond spreads. The latter reflect both credit and liquidity differences between national bonds. An innovative aspect of the approach lies in the modeling of intertwined credit-and liquidity-related crisis regimes. We find that a substantial share of the changes in euro-area yield differentials is liquidity-driven during the financial-crisis period. Once liquidity-pricing effects and risk premiums are filtered out of the spreads, we obtain estimates of the actual default probabilities. They are significantly lower than their risk-neutral counterparts, which is consistent with the existence of a non-diversifiable euro-area sovereign credit risk. for helpful discussions and comments. We are also grateful to seminar participants the Bank of Canada and the Bundesbank. An earlier version of this paper was circulated under the title " Credit and liquidity risks in euro-area yield curves. " We thank Beatrice Saes-Escorbiac and Aurélie Touchais for excellent research assistance. Any remaining errors are ours. The views expressed in this paper are ours and do not necessarily reflect the views of the Banque de France.

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