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Incomplete markets, liquidation risk, and the term structure of interest rates

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  • Challe, Edouard
  • Le Grand, François
  • Ragot, Xavier

Abstract

We analyse the term structure of interest rates in a general equilibrium model with incomplete markets, borrowing constraint, and positive net supply of government bonds. Uninsured idiosyncratic shocks generate bond trades, while aggregate shocks cause fluctuations in the trading price of bonds. Long bonds command a “liquidation risk premium” over short bonds, because they may have to be liquidated before maturity – following a bad idiosyncratic shock – precisely when their resale value is low – due to the simultaneous occurrence of a bad aggregate shock. Our framework endogenously generates limited cross-sectional wealth heterogeneity among the agents (despite the presence of uninsured idiosyncratic shocks), which allows us to characterise analytically the shape of the entire yield curve, including the yields on bonds of arbitrarily long maturities. Agentsʼ desire to hedge the idiosyncratic risk together with their fear of having to liquidate long bonds at unfavourable terms implies that a greater bond supply raises the level of the yield curve, while an increase in the relative supply of long bonds raises its slope.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Economic Theory.

Volume (Year): 148 (2013)
Issue (Month): 6 ()
Pages: 2483-2519

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Handle: RePEc:eee:jetheo:v:148:y:2013:i:6:p:2483-2519

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Web page: http://www.elsevier.com/locate/inca/622869

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Keywords: Incomplete markets; Borrowing constraint; Yield curve;

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Cited by:
  1. Xavier Ragot & Edouard Challe, 2011. "Precautionary Saving over the Business Cycle," 2011 Meeting Papers 517, Society for Economic Dynamics.
  2. Le Grand, F. & Ragot, X., 2010. "Prices and volumes of options: A simple theory of risk sharing when markets are incomplete," Working papers 302, Banque de France.
  3. Edouard Challe & Xavier Ragot, 2010. "Aggregate Consumption in Times of Crisis: The Role of Financial Frictions -super-1," CESifo Economic Studies, CESifo, vol. 56(4), pages 627-648, December.

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