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

  • Edouard Challe

    (Department of Economics, Ecole Polytechnique - Polytechnique - X - CNRS - Centre National de la Recherche Scientifique, CREST - Centre de Recherche en Économie et Statistique - INSEE - École Nationale de la Statistique et de l'Administration Économique, Banque de France)

  • François Le Grand

    (EMLYON Business school - EMLYON Business School, ETH - Eidgenössische Technische Hochschule [Zürich])

  • Xavier Ragot

    (Centre de recherche de la Banque de France - Banque de France, PSE - Paris School of Economics, PSE - Paris-Jourdan Sciences Economiques - ENS Paris - École normale supérieure - Paris - INRA - Institut National de la Recherche Agronomique - EHESS - École des hautes études en sciences sociales - École des Ponts ParisTech (ENPC) - CNRS - Centre National de la Recherche Scientifique)

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 uctuations 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. Agents desire to hedge the idiosyncratic risk together with their fear of having to liquidate long bonds at unfavourable terms imply 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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