Frontiers in Applied Mathematics and Statistics (Dec 2016)
Disentangling the information content of government bonds and credit default swaps: An empirical analysis on sovereigns and banks
Abstract
We propose a multi-factor Gaussian model to analyze the dynamicsof sovereign bond yields, as well as sovereign and banks CDS quotes. This paperhas three objectives (all of them with relevant implications from a supervisoryperspective): (1) disentangling the credit risk component of sovereign bonds fromthe interest rate component; (2) exploring the sovereign CDS-bond basis, i.e. thedi□erence between sovereign CDS quotes and the corresponding bond yields; (3)inferring from CDS quotes the idiosyncratic component of a bank credit risk andanalyzing its relation with sovereign risk. We cast the model in a state-spaceform with linear measurement function. To calibrate the model we consider amaximum likelihood estimation together with a Kalman □lter method in whichboth the gradient vector and the Hessian matrix to be used in the optimizationcan be computed in closed form.
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