Endogenous state prices, liquidity, default, and the yield curve

Raphael Espinoza (), Charles Goodhart and Dimitrios Tsomocos

LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library

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). 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 agents’ 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.

Keywords: cash-in-advance constraints; risk-neutral probabilities; state prices; term structure of interest rates (search for similar items in EconPapers)
JEL-codes: E43 G12 (search for similar items in EconPapers)
Pages: 28 pages
Date: 2007-02-01
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http://eprints.lse.ac.uk/24479/ Open access version. (application/pdf)

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 (2007)
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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