The Term Structure of Interest Rates in a Heterogeneous Monetary Union

James Costain, Galo Nuño Barrau and Carlos Thomas

No 2223, Working Papers from Banco de España

Abstract: The highly asymmetric reaction of euro area yield curves to the announcement of the ECB’s pandemic emergency purchase programme (PEPP) is hard to reconcile with the standard “duration risk extraction” view of the transmission of central banks’ asset purchase policies. This observation motivates us to build a no-arbitrage model of the term structure of sovereign interest rates in a two-country monetary union, in which one country issues default-free bonds and the other issues defaultable bonds. We derive an affine term structure solution, and we decompose yields into term premium and credit risk components. In an extension, we endogenise the peripheral default probability, showing that the possibility of rollover crises makes it an increasing function of bond supply net of central bank holdings. We calibrate the model to Germany and Italy, showing that it matches well the reaction of these countries’ yield curves to the PEPP announcement. A channel we call “default risk extraction” accounts for most of the impact on Italian yields. The programme’s flexible design substantially enhanced this impact.

Keywords: sovereign default; quantitative easing; yield curve; affine model; COVID-19 crisis; ECB; pandemic emergency purchase programme (search for similar items in EconPapers)
JEL-codes: E5 F45 G12 (search for similar items in EconPapers)
Pages: 60 pages
Date: 2022-06
New Economics Papers: this item is included in nep-cba, nep-eec, nep-mon and nep-opm
References: Add references at CitEc
Citations: View citations in EconPapers (11)

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Related works:
Working Paper: The term structure of interest rates in a heterogeneous monetary union (2024)
Working Paper: The Term Structure of Interest Rates in a Heterogeneous Monetary Union (2024)
Working Paper: The Term Structure of Interest Rates in a Heterogeneous Monetary Union (2022)
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Persistent link: https://EconPapers.repec.org/RePEc:bde:wpaper:2223

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