Abstract

http://ssrn.com/abstract=1705986
 
 

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Incomplete Markets, Liquidation Risk, and the Term Structure of Interest Rates


Edouard Challe


Ecole Polytechnique

Francois Le Grand


EMLYON Business School

Xavier Ragot


National Center for Scientific Research (CNRS)

October 1, 2010


Abstract:     
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

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Date posted: November 10, 2010  

Suggested Citation

Challe, Edouard and Le Grand, Francois and Ragot, Xavier, Incomplete Markets, Liquidation Risk, and the Term Structure of Interest Rates (October 1, 2010). Available at SSRN: http://ssrn.com/abstract=1705986 or http://dx.doi.org/10.2139/ssrn.1705986

Contact Information

Edouard Challe (Contact Author)
Ecole Polytechnique ( email )
Ecole Polytechnique
Department of Economics
Paris, 75005
France
François Le Grand
EMLYON Business School ( email )
23 Avenue Guy de Collongue
Ecully, 69132
France
Xavier Ragot
National Center for Scientific Research (CNRS)
75013 Paris, 94204
France
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