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

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  • Challe, E.
  • Le Grand, F.
  • Ragot, X.

Abstract

We analyze the term structure of real interest rates in a general equilibrium model with incomplete markets and borrowing constraints. Agents are subject to both aggregate and idiosyncratic income shocks, which latter may force them into early portfolio liquidation in a bad aggregate state. We derive a closed-form equilibrium with limited agent heterogeneity (despite market incompleteness), which allows us to produce analytical expressions for bond prices and returns at any maturity. The attractiveness of bonds as liquidity makes aggregate bond demand downward-sloping, so that greater bond supply raises both the level and the slope of the yield curve. Moreover, time-variations in liquidation risk are shown to help explain the rejection of the Expectations Hypothesis.

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Bibliographic Info

Paper provided by Banque de France in its series Working papers with number 301.

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Length: 44 pages
Date of creation: 2010
Date of revision:
Handle: RePEc:bfr:banfra:301

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Keywords: Incomplete markets; yield curve; borrowing constraints.;

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Cited by:
  1. 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.
  2. Xavier Ragot & Edouard Challe, 2011. "Precautionary Saving over the Business Cycle," 2011 Meeting Papers 517, Society for Economic Dynamics.
  3. Xavier Ragot & Francois Le Grand, 2010. "Prices and volumes of options: A simple theory of risk sharing when markets are incomplete," 2010 Meeting Papers 300, Society for Economic Dynamics.

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