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Interest rate, liquidity, and sovereign risk: derivative-based VaR

Mariya Gubareva (Department of Economics and Finance, Instituto Politecnico de Lisboa Instituto Superior de Contabilidade e Administracao de Lisboa, Lisbon, Portugal and Lisbon School of Economics and Management, Universidade de Lisboa, Lisbon, Portugal)
Maria Rosa Borges (Lisbon School of Economics and Management, Universidade de Lisboa, Lisbon, Portugal)

Journal of Risk Finance

ISSN: 1526-5943

Article publication date: 21 August 2017




The purpose of this paper is to study connections between interest rate risk and credit risk and investigate the inter-risk diversification benefit due to the joint consideration of these risks in the banking book containing sovereign debt.


The paper develops the historical derivative-based value at risk (VaR) for assessing the downside risk of a sovereign debt portfolio through the integrated treatment of interest rate and credit risks. The credit default swaps spreads and the fixed-leg rates of interest rate swap are used as proxies for credit risk and interest rate risk, respectively.


The proposed methodology is applied to the decade-long history of emerging markets sovereign debt. The empirical analysis demonstrates that the diversified VaR benefits from imperfect correlation between the risk factors. Sovereign risks of non-core emu states and oil producing countries are discussed through the prism of VaR metrics.

Practical implications

The proposed approach offers a clue for improving risk management in regards to banking books containing government bonds. It could be applied to access the riskiness of investment portfolios containing the wider spectrum of assets beyond the sovereign debt. The approach represents a useful tool for investigating interest rate and credit risk interrelation.


The proposed enhancement of the traditional historical VaR is twofold: usage of derivative instruments’ quotes and simultaneous consideration of the interest rate and credit risk factors to construct the hypothetical liquidity-free bond yield, which allows to distil liquidity premium.



Financial support by the Instituto Politécnico de Lisboa - IPL (Lisbon Polytechnic Institute), under the projects IPL/2016/MacroModel/ISCAL and IPL/2017/MacroTools/ISCAL, is gratefully acknowledged.

Financial support by FCT (Fundação para a Ciência e a Tecnologia), Portugal is gratefully acknowledged. This article is part of the Strategic Project (UID/ECO/00436/2013).


Gubareva, M. and Borges, M.R. (2017), "Interest rate, liquidity, and sovereign risk: derivative-based VaR", Journal of Risk Finance, Vol. 18 No. 4, pp. 443-465.



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Copyright © 2017, Emerald Publishing Limited

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