 Incomplete markets, liquidation risk, and the term structure of interest ratesEdouard Challe, François Le Grand and Xavier Ragot Journal of Economic Theory, 2013, vol. 148, issue 6, 2483-2519 Abstract: 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 fluctuations 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. Agentsʼ desire to hedge the idiosyncratic risk together with their fear of having to liquidate long bonds at unfavourable terms implies 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. Keywords: Incomplete markets; Borrowing constraint; Yield curve (search for similar items in EconPapers) Downloads: (external link) Related works: Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text Persistent link: https://EconPapers.repec.org/RePEc:eee:jetheo:v:148:y:2013:i:6:p:2483-2519 DOI: 10.1016/j.jet.2013.10.003 Access Statistics for this article Journal of Economic Theory is currently edited by A. Lizzeri and K. Shell More articles in Journal of Economic Theory from Elsevier |
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