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

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

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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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
Contact details of provider: Postal: Banque de France 31 Rue Croix des Petits Champs LABOLOG - 49-1404 75049 PARIS
Web page: http://www.banque-france.fr/
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