Incomplete Markets, Liquidation Risk, and the Term Structure of Interest Rates
Francois Le Grand
EMLYON Business School
National Center for Scientific Research (CNRS)
October 1, 2010
We analyze the term structure of real interest rates in a general equilibrium model with incomplete markets and borrowing constraints. Agents are subject to both aggregate and idiosyncratic income shocks, which latter may force them into early portfolio liquidation in a bad aggregate state. We derive a closed-form equilibrium with limited agent heterogeneity (despite market incompleteness), which allows us to produce analytical expressions for bond prices and returns at any maturity. The attractiveness of bonds as liquidity makes aggregate bond demand downward-sloping, so that greater bond supply raises both the level and the slope of the yield curve. Moreover, time-variations in liquidation risk are shown to help explain the rejection of the Expectations Hypothesis.
Number of Pages in PDF File: 44
Keywords: Incomplete markets, yield curve, borrowing constraints
JEL Classification: E21, E43, G12
Date posted: November 10, 2010
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