Endogenous State Prices, Liquidity, Default, and the Yield Curve
AbstractWe show, in an exchange economy with default, liquidity constraints and no aggregate uncertainty, that state prices in a complete markets general equilibrium are a function of the supply of liquidity by the Central Bank. Our model is derived along the lines of Dubey and Geanakoplos (1992). Two agents trade goods and nominal assets (Arrow-Debreu (AD) securities) to smooth consumption across periods and future states, in the presence of cashin-advance financing costs. We show that, with Von Neumann-Morgenstern logarithmic utility functions, the price of AD securities, are inversely related to liquidity. The upshot of our argument is that agentsâ€™ expectations computed using risk-neutral probabilities give more weight in the states with higher interest rates. This result cannot be found in a Lucas-type representative agent general equilibrium model where there is neither trade or money nor default. Hence, an upward yield curve can be supported in equilibrium, even though short-term interest rates are fairly stable. The risk-premium in the term structure is therefore a pure default risk premium.
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Bibliographic InfoPaper provided by Oxford Financial Research Centre in its series OFRC Working Papers Series with number 2007fe01.
Date of creation: 2007
Date of revision:
cash-in-advance constraints; risk-neutral probabilities; state prices; term structure of interest rate;
Other versions of this item:
- Raphael Espinoza & Dimitrios Tsomocos & Charles Goodhart, 2007. "Endogenous State Prices, Liquidity, Default, and the Yield Curve," FMG Discussion Papers dp583, Financial Markets Group.
- Raphael A. Espinoza & Dimitrios P Tsomocos, 2007. "Endogenous State Prices, Liquidity, Default, and the Yield Curve," Economics Series Working Papers 2007-FE-01, University of Oxford, Department of Economics.
- Raphael A. Espinoza & Charles A. E. Goodhart & Dimitrios P. Tsomocos, 2006. "Endogenous State Prices, Liquidity, Default, and the Yield Curve," OFRC Working Papers Series 2006fe15, Oxford Financial Research Centre.
- E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
This paper has been announced in the following NEP Reports:
- NEP-ALL-2007-03-03 (All new papers)
- NEP-CBA-2007-03-03 (Central Banking)
- NEP-CFN-2007-03-03 (Corporate Finance)
- NEP-DGE-2007-03-03 (Dynamic General Equilibrium)
- NEP-FMK-2007-03-03 (Financial Markets)
- NEP-MAC-2007-03-03 (Macroeconomics)
- NEP-UPT-2007-03-03 (Utility Models & Prospect Theory)
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