UNCOVERING THE COMMON RISK-FREE RATE IN THE EUROPEAN MONETARY UNION
Article first published online: 31 JUL 2013
Copyright © 2013 John Wiley & Sons, Ltd.
Journal of Applied Econometrics
Volume 29, Issue 3, pages 394–414, April/May 2014
How to Cite
Wagenvoort, R. J. L. M. and Zwart, S. (2014), UNCOVERING THE COMMON RISK-FREE RATE IN THE EUROPEAN MONETARY UNION. J. Appl. Econ., 29: 394–414. doi: 10.1002/jae.2335
- Issue published online: 2 APR 2014
- Article first published online: 31 JUL 2013
- Manuscript Revised: 24 NOV 2012
- Manuscript Received: 5 JAN 2011
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.