Working Paper: NBER ID: w12781
Authors: Wei Xiong; Hongjun Yan
Abstract: 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.
Keywords: Heterogeneous expectations; Bond markets; Yield curve; Volatility
JEL Codes: E43; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| heterogeneous expectations (D84) | speculative trading (G13) |
| speculative trading (G13) | bond yield volatility (E43) |
| belief dispersion (D80) | trading volume (G15) |
| trading volume (G15) | bond yield volatility (E43) |
| fluctuations in agents' beliefs (D84) | time-varying risk premia (C22) |
| relative wealth (D31) | time-varying risk premia (C22) |
| time-varying risk premia (C22) | negative correlation with yield spreads (G12) |