Endogenous State Prices, Liquidity, Default, and the Yield Curve

Raphael Espinoza (), Dimitrios Panayotis Tsomocos and Charles Goodhart ()

FMG Discussion Papers from Financial Markets Group

Abstract: We 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). Twoagents trade goods and nominal assets (Arrow-Debreu (AD) securities) to smooth consumption across periods and future states, in the presence of cash-in-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 agents’ expectations computedusing 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.Keywords: cash-in-advance constraints; risk-neutral probabilities; state prices; term structure of interest ratesJEL Classification: E43; G12

Date: 2007-02

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Related works:
Working Paper: Endogenous State Prices, Liquidity, Default, and the Yield Curve (2007)
Working Paper: Endogenous State Prices, Liquidity, Default, and the Yield Curve (2006)
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