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

Edouard Challe, François Le Grand, Xavier Ragot, Paris-Jourdan Sciences, Economiques Laboratoire D'economie, Edouard Challe, François Le Grand, Xavier Ragot
unpublished
We construct a general equilibrium model with incomplete markets and borrowing constraints , in order to study the term structure of real interest rates. Agents are subject to both aggregate and idiosyncratic income shocks, which latter may force them into early portfolio liquidation whilst in recession. We derive a closed-form equilibrium with limited agents' het-erogeneity (despite market incompleteness), which allows us to derive analytical expressions for bond prices and returns at any
more » ... returns at any maturity. The desirability of bonds as liquidity makes the aggregate bond demand downward-sloping. One consequence of this is that a larger bond supply raises both the level and the slope of the yield curve.
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