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

44 Pages Posted: 10 Nov 2010  

Edouard Challe

Ecole Polytechnique

Francois Le Grand

EMLYON Business School

Xavier Ragot

National Center for Scientific Research (CNRS)

Date Written: 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.

Keywords: Incomplete markets, yield curve, borrowing constraints

JEL Classification: E21, E43, G12

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: https://ssrn.com/abstract=1705986 or http://dx.doi.org/10.2139/ssrn.1705986

Edouard Challe (Contact Author)

Ecole Polytechnique ( email )

Ecole Polytechnique
Department of Economics
Paris, 75005
France

Fran├žois Le Grand

EMLYON Business School ( email )

23 Avenue Guy de Collongue
Ecully, 69132
France

Xavier Ragot

National Center for Scientific Research (CNRS)

3, rue Michel-Ange
Paris cedex 16, 75794
France

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