## ASSET PRICING MODEL: The yield curve

With only one liquidity-constrained state, the price in information state an of an asset к with constant expected dividend is, as we have seen,

Equations (24) and (25) state that, in absolute as well as relative terms, the volatility of an asset’s price is proportional to the square of the asset’s liquidity premium. Because prices move slowly, an immediate corollary is that an asset’s price volatility is serially correlated; that is, we predict temporal clustering of an asset’s volatility.

Equations (26) and (27) state that the volatility ratio of two assets is constant over time. Assets volatilities move together because they are driven by the same news concerning the likelihood of a liquidity shortage.

Returning to formulae (24) and (25), we note that volatility is also proportional to the informativeness Ss(c%) of the signal accruing at subdate n + 1. With two states, this informativeness measure is generally state-dependent, rendering these results less useful. To illustrate a case with constant informativeness, suppose that information accrues according to a Bernoulli process: At each subdate n, with probability Л € (0,1), the market learns that the economy will not be in the bad state of nature (/я(о’п) = 0). If that happens, the economy becomes an “Arrow-Debreu economy,” in which assets command no liquidity premium and hence qk{&m) = 1 for all m > n. In this absorbing state, informativeness maybe taken equal to 0. With probability 1 — Л, the economy remains an “LAPM economy” and /н(&п) = (1 — A simple computation shows that in this example:

There is price volatility as long as the liquidity premium is strictly positive. If news accrues that the economy will be replete with liquidity, the liquidity premium goes to zero as will the volatility of prices for all assets with constant expected payoffs.

The yield curve

The slope of the yield curve and price risk

The theoretical and econometric research on the term structure of interest rates traditionally views the corporate sector as a veil in the sense that the yield curve is not influenced by asset liability management (ALM). Many believe, however, that corporate liquidity demand affects the term structure. First, while debt markets are segmented, there is enough substitutability across maturities to induce long and short rates to move up and down together (Culbertson, 1957). Duration analysis, stripping activities and more generally financial engineering and innovation (answering the question of “who is the natural investor for the new security?”) provide indirect evidence for segmentation. A number of factors such as fiscal incentives, the creation of pension funds, new accounting and prudential rules for intermediaries, and the leverage of the real and financial sectors are likely to affect the demand for maturities differentially, thereby influencing the term structure. Second, the maturity structure of government debt seems to play a role in the determination of the term structure, a fact that is not accounted for in Ricardian consumption-based asset pricing models.