ASSET PRICING MODEL: The yield curve 4

The price differential between short- and long-term bonds here reflects a more general theme, namely that the liquidity approach to asset pricing implies a skewness in risk tolerance. What matters is the average coupon delivered in states of pressing liquidity need. The term premium stems from the fact that a short-term bond delivers 1 unit for sure in such states, while the date-1 price of the longterm bond is negatively correlated with the marginal liquidity service m(-). The difference q — Q measures the cost of hedging against the date-1 coupon/price risk on long-term bonds.

Non neutrality of price risk. Long-term bonds would provide a better liquidity service (namely the same service as short-term bonds) if there were no uncertainty about inflation or if no information about в arrived at date 1. This contrasts with an Arrow-Debreu economy, in which early arrival of information never is harmful. Such information has no impact in an endowment economy, and may generate social gains in a production economy because of improved decision making. Our model features a logic similar to Hirshleifer’s (1971) idea that early information arrival may make agents worse off.

Our model differs from Hirshleifer’s, in that in his model information arrives before entrepreneurs and investors sign a contract. In our model it is the investors’ inability to commit to bringing in funds at date 1 that constrains contracting and makes information leakage problematic. Put differently, investors cannot offer entrepreneurs insurance against variations in the price of long-term bonds. If the price of long-term bonds is negatively correlated with the firm’s liquidity needs, as is the case here, long-term bonds become inferior liquidity buffers to short-term bonds. payday loan

Neutrality of pure price risk. Let us follow section 4 and assume that news about the date-1 state accrues between date 0 and date 1, at subdates n = 1,…, N; that is, at each subdate n, a signal an accrues that is informative about the date-1 income and/or the coupon on the long-term bond. Then, the prices of short-and long-term bonds adjust from their date-0 values q and Q to q(an) and Q(an). This price risk, however, has no impact on the date-0 prices q and Q which remain given by (28) and (29), since the corporate sector in equilibrium does not reshuffle its portfolio of liquid assets (this is the point made earlier that capital gains and losses on financial assets have offsetting effects.) In other words, price risk has no impact on the slope of the date-0 yield curve. On the other hand, news affects the slope of the yield curve at subdates.

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