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Title:Uncovering the common risk free rate in the European Monetary Union PDF Logo
Authors:Wagenvoort, Rien
Zwart, Sanne
Issue Date:2010
Series/Report no.:Economic and financial reports / European Investment Bank 2010/05
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.
Subjects:factor analysis
risk free interest rate
sovereign bond
benchmark
JEL:C19
E43
G12
Document Type:Working Paper
Appears in Collections:Economic and Financial Reports, European Investment Bank (EIB)

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