Default, liquidity and crises: an econometric framework∗

In this paper, extending the work by Gourieroux, Monfort and Polimenis (2006) [78], we present a general discrete-time affine framework aimed at jointly modeling yield curves that are associated with different issuers. The underlying fixed-income securities may differ in terms of credit quality and/or in terms of liquidity. The risk factors follow discrete-time Gaussian processes, with drifts and variance-covariance matrices that are subject to regime shifts described by a Markov chain with (historical) non-homogenous transition probabilities. While flexible, the model remains tractable and amenable to empirical estimation. This is illustrated by an application on euro-area government yields. Specifically, the common dynamics of ten euro-area government yield curves are estimated using weekly data spanning the period from 1999 to early 2010. The dynamics of the yield curves are satisfyingly explained by both observable factors and unobservable ones. Among the latter, we exhibit a euro-area-wide liquidity-related latent factor. The estimation results suggest that an important share of the changes in euro-area yield differentials is liquidity-driven. JEL codes: E43, E44, E47, G12, G24.