Heterogeneous Expectations and Bond Markets

52 Pages Posted: 23 Dec 2006 Last revised: 18 May 2007

See all articles by Hongjun Yan

Hongjun Yan

DePaul University

Wei Xiong

Princeton University - Department of Economics; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: December 2006

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.

Suggested Citation

Yan, Hongjun and Xiong, Wei, Heterogeneous Expectations and Bond Markets (December 2006). NBER Working Paper No. w12781. Available at SSRN: https://ssrn.com/abstract=953204

Hongjun Yan

DePaul University ( email )

1 East Jackson Blvd.
Chicago, IL 60604
United States

HOME PAGE: http://sites.google.com/view/hongjunyan

Wei Xiong (Contact Author)

Princeton University - Department of Economics ( email )

Princeton, NJ 08544-1021
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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