Empirical Analysis of European Government Yield Spreads

Abstract

This paper focuses on the dynamics of yield spreads deducted from government bonds issued by member states of the European Monetary Union (EMU). A descriptive analysis shows that there is a substantial and volatile spread between government zero coupon yields of EMU member countries and German Bund yields. These yield spreads form an important source of additional risk that has to be taken into account by any pricing or risk management model based on or dealing with EMU government bonds. We extract risk factors driving the observed yield spreads by employing a multi-issuer version of the model originally proposed by Duffie and Singleton (1999). We adopt a state-space approach to implement the model that enables us to extract factor series and model parameters simultaneously. We find strong empirical evidence for a global factor that mainly represents the average level of the yield spreads and for a country specific factor for each issuer. Our findings indicate that it may be justified to implement a simplified version of the multi-issuer model that sufficiently captures the main features of the data. Filter