Are the Risk-Free Interest Rates Correlated with Sovereign Default Intensities?

Abstract

This study proposes a new methodology to estimate credit default swap- (CDS-) adjusted risk-free interest rates and sovereign default intensities. Government bond yields in a local currency and CDS premiums in a foreign currency are used to estimate the CDS-adjusted risk-free interest rate, which is adjusted for the default risk of a government and is immune to its correlation with the sovereign default intensity. The method is based on the fact that risk-free interest rates and sovereign default intensities in the same currency are correlated, whereas the correlations between the risk-free interest rates in a foreign currency and the default intensities are close to zero except during worldwide financial turmoil such as the European sovereign debt crisis. The methodology is applied to the German and US markets and the CDS-adjusted risk-free interest rates in US dollars and euros, and the sovereign default intensities of Germany and the United States are successfully estimated.