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Positive liquidity spillovers from sovereign bond-backed securities

Author

Listed:
  • Dunne, Peter G.
Abstract
This paper contributes to the debate concerning the benefits and disadvantages of introducing a European Sovereign Bond-Backed Securitisation (SBBS) to address the need for a common safe asset that would break destabilising bank-sovereign linkages. The analysis focuses on assessing the effectiveness of hedges incurred while making markets in individual euro area sovereign bonds by taking offsetting positions in one or more of the SBBS tranches. Tranche yields are estimated using a simulation approach. This involves the generation of sovereign defaults and allocation of the combined credit risk premium of all the sovereigns, at the end of each day, to the SBBS tranches according to the seniority of claims under the proposed securitisation. Optimal hedging with SBBS is found to reduce risk exposures substantially in normal market conditions. In volatile conditions, hedging is not very effective but leaves dealers exposed to mostly idiosyncratic risks. These remaining risks largely disappear if dealers are diversified in providing liquidity across country-specific secondary markets and SBBS tranches. Hedging each of the long positions in a portfolio of individual sovereigns results in a risk exposure as low as that borne by holding the safest individual sovereign bond (the Bund). JEL Classification: D47, E44, G12, G24, C53, C58

Suggested Citation

  • Dunne, Peter G., 2018. "Positive liquidity spillovers from sovereign bond-backed securities," ESRB Working Paper Series 67, European Systemic Risk Board.
    • Handle: RePEc:srk:srkwps:201867
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    File URL: https://www.esrb.europa.eu//pub/pdf/wp/esrb.wp67.en.pdf
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    References listed on IDEAS

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    Cited by:

    1. Gómez-Puig, Marta & Pieterse-Bloem, Mary & Sosvilla-Rivero, Simón, 2023. "Dynamic connectedness between credit and liquidity risks in euro area sovereign debt markets," Journal of Multinational Financial Management, Elsevier, vol. 68(C).
    2. Lars Stentoft, 2020. "Computational Finance," JRFM, MDPI, vol. 13(7), pages 1-4, July.
    3. Jeromin Zettelmeyer & Álvaro Leandro, 2018. "The Search for a Euro Area Safe Asset," Working Paper Series WP18-3, Peterson Institute for International Economics.
    4. Cronin, David & Dunne, Peter G., 2019. "How effective are sovereign bond-backed securities as a spillover prevention device?," Journal of International Money and Finance, Elsevier, vol. 96(C), pages 49-66.
    5. Daragh Clancy & Peter G. Dunne & Pasquale Filiani, 2019. "Liquidity and tail-risk interdependencies in the euro area sovereign bond market," Working Papers 41, European Stability Mechanism.

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    More about this item

    Keywords

    dealer behaviour; liquidity bid-ask spread; safe assets; securitisation;
    All these keywords.

    JEL classification:

    • D47 - Microeconomics - - Market Structure, Pricing, and Design - - - Market Design
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage
    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics

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