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Peter G. Dunne

29 January 2018
WORKING PAPER SERIES - No. 67
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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 Code
D47 : Microeconomics→Market Structure and Pricing→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, Ratings and Ratings Agencies
C53 : Mathematical and Quantitative Methods→Econometric Modeling→Forecasting and Prediction Methods, Simulation Methods
C58 : Mathematical and Quantitative Methods→Econometric Modeling→Financial Econometrics
29 January 2018
WORKING PAPER SERIES - No. 66
Details
Abstract
Brunnermeier et al. (2017) propose the introduction of sovereign bond-backed securities (SBBS) in the euro area. It and other papers address how the securitisation would insulate senior security holders from actual default-related losses. This article generalises the assessment by using the VAR-based Diebold & Yilmaz (2012) spillover index methodology to assess potential attenuation of the spillover of shocks in holding-period returns across asset markets from the introduction of SBBS. This is made possible by employing SBBS yields estimated from historical euro area member state sovereign bond yields using Monte Carlo methods, as described in Schönbucher (2003). The econometric results show that (i) SBBS tranching protects senior SBBS holders by reducing the spillover of shocks from the higher-risk peripheral member states to it; (ii) spillovers from high risk sovereigns to a weighted portfolio are much higher than those to the senior SBBS; (iii) a smaller junior SBBS tranche, and the introduction of a mezzanine security, reduces spillover from it to the senior SBBS; and (iv) rolling window analysis indicates that the spillover of shocks from the junior tranche to the senior tranche declines during a period of financial stress.
JEL Code
C58 : Mathematical and Quantitative Methods→Econometric Modeling→Financial Econometrics
G11 : Financial Economics→General Financial Markets→Portfolio Choice, Investment Decisions
G12 : Financial Economics→General Financial Markets→Asset Pricing, Trading Volume, Bond Interest Rates
G17 : Financial Economics→General Financial Markets→Financial Forecasting and Simulation
29 January 2018
WORKING PAPER SERIES - No. 65
Details
Abstract
The risk reducing benefits of the sovereign bond-backed security (SBBS) proposal of Brunnermeier et al. (2016) have been assessed in terms of the likely losses that different kinds of holders would suffer under simulated default scenarios. However, the effects of mark-to-market losses that may occur when there is rising uncertainty about defaults, or when self-fulfilling destablising dynamics are prevalent, have not yet been examined. We apply the “VAR-for-VaR” method of Manganelli et al. (2015) and the Marginal Expected Shortfall (MES) approach of Brownlees and Engle (2012, 2017) to estimated yields of SBBS to assess how ex ante exposures and marginal contributions to systemic risk are likely to play-out for different SBBS tranches under various securitisation structures. We compare these with exposures/MES of single sovereigns and a diversified portfolio of sovereigns. We find that the senior SBBS has extremely low ex ante tail risk and that, like the low-risk sovereigns, it acts as a hedge against extreme market-wide yield movements. The mezzanine SBBS has tail risk exposure similar to that of Italian and Spanish bonds. Yields on SBBS appear to be adequate compensation for their risks when compared with single sovereigns or a diversified portfolio.
JEL Code
E43 : Macroeconomics and Monetary Economics→Money and Interest Rates→Interest Rates: Determination, Term Structure, and Effects
E44 : Macroeconomics and Monetary Economics→Money and Interest Rates→Financial Markets and the Macroeconomy
E52 : Macroeconomics and Monetary Economics→Monetary Policy, Central Banking, and the Supply of Money and Credit→Monetary Policy
E53 : Macroeconomics and Monetary Economics→Monetary Policy, Central Banking, and the Supply of Money and Credit
G12 : Financial Economics→General Financial Markets→Asset Pricing, Trading Volume, Bond Interest Rates
G14 : Financial Economics→General Financial Markets→Information and Market Efficiency, Event Studies, Insider Trading