Towards a Common European Monetary Union Risk Free Rate

Abstract

A common European bond would yield a common European Monetary Union risk free rate. We present tentative estimates of this common risk free for the European Monetary Union countries from 2004 to 2009 using variables motivated by a theoretical portfolio selection model. First, we analyze the determinants of EMU sovereign yield spreads and find significant effects of the credit quality, macro, correlation, and liquidity variables. However, their effects are different before and after the current financial crisis, being stronger in the latter period. Robustness tests with different data frequencies, benchmarks, liquidity variables, cross section regressions and balanced panels confirm the initial results. We propose four different estimates of the common risk free rate and show that, in most cases, this common rate could imply savings in borrowing costs for all the countries involved. it for a given set of countries and discuss its uses for monetary policy management and its implication for financial markets' integration. The results suggest that this common rate, in most cases, could imply savings in borrowing costs for all the countries involved.The possibility of a common European bond has attracted the interest of the financial press and is receiving increased attention from policy makers 1 . There are potential wider benefits for the Eurozone as well as specific benefits for market agents such as issuers, dealers, and investors. A large common bond issue could have benefits even for countries with low credit risk (Germany, France), as it could rival American's treasuries market for liquidity. Moreover a single issuer would make EMU bonds more attractive to investors in large foreign-exchange reserves (China, Japan) and enhance the euro's standing as a reserve currency, as well as lowering borrowing costs for all countries that took part in it 2 .This common risk free rate can be used as a benchmark for measuring the benefits from financial market integration in the EMU. We conjecture and provide some evidence that our estimates of this rate would be close to what a common EMU-based single bond would yield for a specified maturity. We can then compare actual rates offered by the different EMU countries with sovereign bonds with this common rate. This allows us to compute the savings in terms of financing cost per year for the different EMU members.1 EPDA(2008EPDA( ,2009 2 Additional technical advantages such as minimizing the possibilities of "squeezes" are discussed in Pagano and Von Thadden (2004) 3Our results suggest that average savings in borrowing costs for all EMU countries are positive irrespective of the common risk free rate measure employed. Of course, there are many institutional design features that must be resolved (seniority, amount relative to total debt issues, guarantee fund, etc.) before such a common bond can be launched.But our paper provides a first insight into one central issue, namely, what should be the required compensation a given country X should pay to the actual issuer (le...

Uncovering the Common Risk‐free Rate in the European Monetary Union

“…Mayordomo et al . () derive the CRF rate by using macro‐economic variables such as the debt to GDP ratio to first estimate country‐specific risk premiums and then compute the CRF rate as the average of the countries' risk‐adjusted bond yields. We do the opposite by first estimating the CRF rate and then derive the risk premiums.…”

Is there Life in the Old Dog Yet? Observations on the Political Economy and Constitutional Viability of Common Debt Issuing in the Euro Area

“…Other proposals suggest to set reinforced fiscal surveillance as a precondition for introducing joint and several liability (European Commission, 2011:8). Costs and benefits should be equalised according to a third group of proposals, which suggest the introduction of a scheme that compensates stronger participating states for gaining some liquidity but assuming the higher credit risks of weaker participating Member States (Favero and Missale, 2012:263;De Grauwe and Moesen, 2009;Mayordomo et al, 2009;Boonstra, 2010;Muellbauer, 2011). Such a compensation scheme indexes the interest to be paid by the participating Member States.…”

“…Such a compensation scheme indexes the interest to be paid by the participating Member States. Since markets are no longer in a position to indicate the costs for the "national share" in Eurobonds, the interest would have to be calculated based on the default risk priced in national bonds issued before the introduction of Eurobonds (De Grauwe and Moesen, 2009), based on Credit Default Swaps (CDS) (Mayordomo et al, 2009), or based on fiscal parameters, e.g. referring to deficits and debt levels, set administratively by a European authority (Muellbauer, 2011;Favero and Missale, 2012:264).…”

Curing and Preventing Euroarea’s Sovereign Debt Crises: Some Issues and a Recipe

“…The Giovannini Group Report (2000) already assumed that there would be large gains in terms of liquidity premium to be obtained with the issuance of a common Eurobond and with the reduction of the current fragmentation of the national debt markets. Indeed, Mayordomo et al (2009) have tried to estimate econometrically the value of the risk free interest rate (without liquidity risk, without influence of country-specific macroeconomic variables, without cross-country correlation and contagion) on a common Eurobond, using data from the period 2004-2009. They find then that this risk free interest rate would imply savings in borrowing costs for all EMU member countries and for all maturities.…”