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

Edouard Challe, François Le Grand and Xavier Ragot
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François Le Grand: EM - EMLyon Business School, ETH Zürich - Eidgenössische Technische Hochschule - Swiss Federal Institute of Technology [Zürich]

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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. 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.

Keywords: Yield curve; Yield curve.; Borrowing constraint; Incomplete markets (search for similar items in EconPapers)
Date: 2013-07-10
New Economics Papers: this item is included in nep-dge
Note: View the original document on HAL open archive server: https://hal.science/hal-00843147v1
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Citations: View citations in EconPapers (27)

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Related works:
Journal Article: Incomplete markets, liquidation risk, and the term structure of interest rates (2013)
Working Paper: Incomplete markets, liquidation risk, and the term structure of interest rates (2013)
Working Paper: Incomplete markets, liquidation risk, and the term structure of interest rates (2013)
Working Paper: Incomplete markets, liquidation risk, and the term structure of interest rates (2013)
Working Paper: Incomplete markets, liquidation risk, and the term structure of interest rates (2013)
Working Paper: Incomplete markets, liquidation risk, and the term structure of interest rates (2013)
Working Paper: Incomplete markets, liquidation risk, and the term structure of interest rates (2010)
Working Paper: Incomplete markets, liquidation risk and the term structure of interest rates (2007)
Working Paper: Incomplete markets, liquidation risk and the term structure of interest rates (2007)
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