English, Article, Journal or magazine article edition: Endogenous State Prices, Liquidity, Default, and the Yield Curve Raphael Espinoza; Dimitrios Tsomocos; Charles Goodhart

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Bookmark: http://trove.nla.gov.au/version/44836
Physical Description
  • preprint
Language
  • English

Edition details

Title
  • Endogenous State Prices, Liquidity, Default, and the Yield Curve
Author
  • Raphael Espinoza
  • Dimitrios Tsomocos
  • Charles Goodhart
Physical Description
  • preprint
Notes
  • We show, in an exchange economy with default, liquidity constraints and no aggregate uncertainty, that state prices in a complete markets general equilibrium are a function of the supply of liquidity by the Central Bank. Our model is derived along the lines of Dubey and Geanakoplos (1992). Twoagents trade goods and nominal assets (Arrow-Debreu (AD) securities) to smooth consumption across periods and future states, in the presence of cash-in-advance financing costs. We show that, with Von Neumann-Morgenstern logarithmic utility functions, the price of AD securities, are inversely related to liquidity. The upshot of our argument is that agents’ expectations computedusing risk-neutral probabilities give more weight in the states with higher interest rates. This result cannot be found in a Lucas-type representative agent general equilibrium model where there is neither trade or money nor default. Hence, an upward yield curve can be supported in equilibrium, even though short-term interest rates are fairly stable. The risk-premium in the term structure is therefore a pure default risk premium.Keywords: cash-in-advance constraints; risk-neutral probabilities; state prices; term structure of interest ratesJEL Classification: E43; G12
  • RePEc:fmg:fmgdps:dp583
Language
  • English
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