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Implied default risk in European interbank lending markets

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Author: Chan, Celene
This project analyzes the spread arising from trading in two portfolios based on the European debt and interbank lending markets. The analysis uses data on sovereign credit default swap spreads, zero-coupon bond yields, European Interbank Offered Rate (EURIBOR) and Euro-denominated plain vanilla interest rate swaps. I focus on the countries that are most embroiled in the European debt crisis: Portugal, Italy, Greece and Spain. The first portfolio I study contains a long position in a 5-year sovereign bond and long position in a sovereign credit default swap that expires in 5-years. The second portfolio consists of rolling over 6-month EURIBOR deposits and selling a 5-year fixed-for-floating interest rate swap. The portfolios are theoretically equivalent in terms of cash flow, and the spread between these investment strategies can be viewed as the implied default risk involved in trading in the interbank market. The spread between the return earned from Portfolio 1 and Portfolio 2 is the implied cost of insuring a EURIBOR bank deposit.
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