Credit Spreads Between German and Italian Sovereign Bonds - Do Affine Models Work?

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Abstract
In this paper we focus on estimating the parameters of two mean-reverting affine models - the gaussian Vasicek and the square-root Cox-Ingersoll-Ross (CIR) model -- for credit spreads between Italian and German Government bonds. Similar to Pearson and Sun (1994) we combine cross-sectional and time-series information of daily observations to estimate the process parameters employing a maximum likelihood method. Our empirical results show that the Vasicek and CIR model describe the risk-free term structure dynamic equally well. However, the Vasicek model seems to explain the spread process better than the CIR model albeit failing to account for all observed shapes of the credit spread structure. The investigated models can be applied to price other credit-sensitive instruments such as credit derivatives and for the management of credit risk.

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