The impact of redenomination risk in the European government bond market

Abstract: This paper provides an empirical analysis of European sovereign yield spreads in times when these may be influenced by redenomination risk arising from the possibility that one or several countries may leave the EMU. To test for redenomination risk impact on yield spreads, I estimate one regression model with a country-specific euro break-up risk indicator and one regression model with an event-indicator assumed to display inter-European reduction in this risk through the intervention by the ECB. The results are robust to changes in liquidity, default risk, volatility and general risk-aversion and provides support for the hypothesis that yield spreads increase with redenomination risk in indebted economies and decrease with redenomination risk in competitive economies. The study however finds no significant short-term yield spread effects of ECB's intervention to reduce the risk of break-up of the EMU.