November 14, 2018
CORE, room C 035
Redenomination Risk and Euro Area Government Bond Market Fragmentation
Angelo Luisi, UCLouvain LFIN
We study the economic and financial drivers of the Euro Area (EA) government bond market, with a particular focus on yields level and spreads, and bond risk premia determinants. Our explanatory variables are (i) EA macroeconomic factors, proxying for the level of inflation and real activity, and (ii) EA financial factors, including redenomination risk - the risk of Euro-denominated assets’ depreciation. Using a multi-market, arbitrage free model, we provide evidence of fragmented response of the EA government bond market to common shocks. For example, German, French, Italian, and Spanish bonds react differently to redenomination risk shocks. A positive shock to redenomination increases the spreads and the expected excess returns in the Spanish and Italian cases, while it does not significantly affect the German and the French bond market. We validate our model by comparing model-implied bond risk premia and realized excess returns. Our model captures the long-term movements of realized excess returns, implying that the proposed risk factors are fundamental drivers of the EA bond market. Finally, we document the effects of the unconventional monetary policies carried out by the European Central Bank on excess returns and on their financial determinants.
(joint with L. Iania)