Pricing EU Sovereign Debt Risk

Abstract

The aim of the analysis is to investigate if bond risk is priced. The idea to examine this topic rises by the interest to analyze in depth the movements of the bond financial market. The general framework reveals an increase of the use of fixed income securities and, consequently, an increase of the use of bonds among investors during last years. Credit institutions started to issue a large multiplicity of financial instruments; an example are perpetual bonds that were not frequently used in the past. Moreover, the increase of government bonds issued was drastic: during the period of the crisis, the European countries frequently asked money to the financial market in order to be able to guarantee their solvability. Consequently, the bond market became more interesting to investors than before and became more attractive and dynamic with respect to the past. The question that I asked to myself was if bonds returns changes affect the decisions of investors and their asset allocation. More in details, it arises the question “Is government bonds risk priced?”. In order to answer this question, the research unfolds in three main paragraphs. In the first part the characteristics of bonds are analyzed and the variables to take into account in order to understand the value of a bond are highlighted. The following features are presented: the relation between the bond and the interest rate, the difference between a long-term and a short-term bond, and some indicators, such as the duration and the Yield curve, that helps to interpret the real movements of a bond. The second part is built in order to investigate the consequences of the 2007 financial crisis and of the crisis of Sovereign Debt. In particular, the information that the Yield curve provides to investors are explained; for example, the analysis of the inversion of the yield curve is one of the main signals of an imminent crisis. Then, the causes and the consequences of the Crisis of Sovereign Debt are studied with the aim to highlight the different economic positions of different countries in the Eurozone. Finally, there is an insight about some strategies of asset allocations commonly used during crisis period that directly affected the bond market. In the Third paragraph, the empirical analysis is deployed. In order to understand if bond risk is priced, a cross sectional asset pricing test is implemented. The process to obtain the final result is composed by a two-step regression. The first regression consists of a time-series regression of the returns of some bond risk factors previously built on the return of some selected portfolios. The second regression is a cross-section regression between the ß obtained in the first regression and the mean of returns of the portfolio selected. The final results are the coefficient "gamma" that are analyzed in order to understand if bond risk is priced. The regressions are done over the period between 01/01/2002 and 01/06/2019. In addition, the same analysis is run also with a specific focus on the crisis period, from 01/01/2011 to 01/01/2016. In this part some statistical insights are presented in order to explain all the passages done to obtain the final results. To complete the analysis, the third part ends with a paragraph in which the weaknesses of the model selected and of the variables used are exposed. Finally, the analysis of results reveals that the bond risk seems to be priced in some circumstances; however, in order to better investigate the topic and to obtain more reliable results, it is probably necessary to develop a different method to run the cross section asset pricing test or, at least, to improve the quality of the method used enhancing the quality of the variables selected.