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

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  • Edouard Challe

    ()
    (DRM - Dauphine Recherches en Management - CNRS : UMR7088 - Université Paris IX - Paris Dauphine)

  • François Le Grand

    (PSE - Paris-Jourdan Sciences Economiques - CNRS : UMR8545 - École des Hautes Études en Sciences Sociales (EHESS) - École des Ponts ParisTech (ENPC) - École normale supérieure [ENS] - Paris, EEP-PSE - Ecole d'Économie de Paris - Paris School of Economics - Ecole d'Économie de Paris)

  • Xavier Ragot

    (PSE - Paris-Jourdan Sciences Economiques - CNRS : UMR8545 - École des Hautes Études en Sciences Sociales (EHESS) - École des Ponts ParisTech (ENPC) - École normale supérieure [ENS] - Paris, EEP-PSE - Ecole d'Économie de Paris - Paris School of Economics - Ecole d'Économie de Paris)

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    Abstract

    We construct a general equilibrium model with incomplete markets and borrowing constraints, in order to study the term structure of real interest rates. Agents are subject to both aggregate and idiosyncratic income shocks, which latter may force them into early portfolio liquidation whilst in recession. We derive a closed-form equilibrium with limited agents heterogeneity (despite market incompleteness), which allows us to derive analytical expressions for bond prices and returns at any maturity. The desirability of bonds as liquidity makes the aggregate bond demand downward-sloping. One consequence of this is that a larger bond supply raises both the level and the slope of the yield curve.

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    File URL: http://halshs.archives-ouvertes.fr/docs/00/58/76/79/PDF/wp200749.pdf
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    Bibliographic Info

    Paper provided by HAL in its series Working Papers with number halshs-00587679.

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    Date of creation: Dec 2007
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    Handle: RePEc:hal:wpaper:halshs-00587679

    Note: View the original document on HAL open archive server: http://halshs.archives-ouvertes.fr/halshs-00587679
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    Related research

    Keywords: incomplete markets ; yield curve ; credit constraints;

    References

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    Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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    1. Duffee, Gregory R, 1996. " Idiosyncratic Variation of Treasury Bill Yields," Journal of Finance, American Finance Association, vol. 51(2), pages 527-51, June.
    2. Amihud, Yakov & Mendelson, Haim, 1991. " Liquidity, Maturity, and the Yields on U.S. Treasury Securities," Journal of Finance, American Finance Association, vol. 46(4), pages 1411-25, September.
    3. Michael J. Fleming, 2002. "Are larger Treasury issues more liquid? Evidence from bill reopenings," Proceedings, Federal Reserve Bank of Cleveland, pages 707-739.
    4. S. Rao Aiyagari, 1993. "Uninsured idiosyncratic risk and aggregate saving," Working Papers 502, Federal Reserve Bank of Minneapolis.
    5. Campbell, John Y & Shiller, Robert J, 1991. "Yield Spreads and Interest Rate Movements: A Bird's Eye View," Review of Economic Studies, Wiley Blackwell, vol. 58(3), pages 495-514, May.
    6. Kehoe, Timothy J & Levine, David K, 2001. "Liquidity Constrained Markets versus Debt Constrained Markets," Econometrica, Econometric Society, vol. 69(3), pages 575-98, May.
    7. R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive 1401, David K. Levine.
    8. Constantinides, George M & Duffie, Darrell, 1996. "Asset Pricing with Heterogeneous Consumers," Journal of Political Economy, University of Chicago Press, vol. 104(2), pages 219-40, April.
    9. Huggett, Mark, 1993. "The risk-free rate in heterogeneous-agent incomplete-insurance economies," Journal of Economic Dynamics and Control, Elsevier, vol. 17(5-6), pages 953-969.
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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. 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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