Term Structure Models with Differences in Beliefs

Abstract:     
This paper studies both theoretically and empirically the link between macroeconomic disagreement and bond markets. Using survey data, we construct proxies of macroeconomic disagreement and nd a number of novel results. First, heterogeneity in beliefs affect the price of risk so that belief dispersion regarding the real economy, inflation, and signals predict excess bond returns with R-squares between 21%- 43%. Second, disagreement explains bond volatilities with high statistical signicance and R-square's of 26% in monthly projections. Third, while around half the information contained in the cross-section of expectations is spanned by the yield curve, there remains large unspanned components important for bond pricing. Fourth, disagreement also contains significant information on trading activity: belief dispersion at 1-year horizon drives up trade at the short end of the yield curve relative to trade at the long end.

Number of Pages in PDF File: 58

Keywords: Fixed income, Term Structure, Difference in Beliefs, Heterogeneous Agent Economies

JEL Classification: D9, E3, E4, G12

working papers series