Heterogeneous Expectations and Bond Markets
This paper presents a dynamic equilibrium model of bond markets, in which two groups of agents hold heterogeneous expectations about future economic conditions. Our model shows that heterogeneous expectations can not only lead to speculative trading, but can also help resolve several challenges to standard representative-agent models of the yield curve. First, the relative wealth fluctuation between the two groups of agents caused by their speculative positions amplifies bond yield volatility, thus providing an explanation for the "excessive volatility puzzle" of bond yields. In addition, the fluctuation in the two groups' expectations and relative wealth also generates time-varying risk premia, which in turn can help explain the failure of the expectation hypothesis. These implications, essentially induced by trading between agents, highlight the importance of incorporating heterogeneous expectations into economic analysis of bond markets.
We are grateful to Markus Brunnermeier, Bernard Dumas, Nicolae Garleanu, Jon Ingersoll, Arvind Krishnamurthy, Owen Lamont, Debbie Lucas, Lin Peng, Monika Piazzesi, Chris Sims, Hyun Shin, Stijn Van Nieuwerburgh, Neng Wang, Moto Yogo, and seminar participants at Bank of Italy, Federal Reserve Bank of New York, NBER Summer Institute, New York University, Northwestern University, Princeton University, University of Chicago, University of Illinois-Chicago, Wharton School, and Yale University for their helpful discussions and comments. The views expressed herein are those of the author(s) and do not necessarily reflect the views of the National Bureau of Economic Research.