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

Raphael A. Espinoza, Dimitrios Tsomocos and A.E. Goodhart

No 2007-FE-01, Economics Series Working Papers from University of Oxford, Department of Economics

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 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 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)
Date: 2007-02-01
References: Add references at CitEc
Citations:

Downloads: (external link)
https://ora.ox.ac.uk/objects/uuid:0e5c7459-b581-4f72-8ac8-0747d1074350 (text/html)

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)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:oxf:wpaper:2007-fe-01

Access Statistics for this paper

More papers in Economics Series Working Papers from University of Oxford, Department of Economics Contact information at EDIRC.
Bibliographic data for series maintained by Anne Pouliquen ( this e-mail address is bad, please contact ).