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Heterogeneous Expectations and Bond Markets

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  • 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.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 12781.

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Date of creation: Dec 2006
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Publication status: published as Xiong, Wei and Hongjun Yan. “Heterogeneous Expectations and Bond Markets." Review of Financial Studies 23, 4 (2010): 1433-1466.
Handle: RePEc:nbr:nberwo:12781

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Cited by:
  1. Aytek Malkhozov & Philippe Mueller & Andrea Vedolin & Gyuri Venter, 2013. "Mortgage Hedging in Fixed Income Markets," FMG Discussion Papers, Financial Markets Group dp722, Financial Markets Group.
  2. Yu, Jianfeng, 2013. "A sentiment-based explanation of the forward premium puzzle," Journal of Monetary Economics, Elsevier, Elsevier, vol. 60(4), pages 474-491.
  3. Robert Edelstein & Peng Liu & Fang Wu, 2012. "The Market for Real Estate Presales: A Theoretical Approach," The Journal of Real Estate Finance and Economics, Springer, Springer, vol. 45(1), pages 30-48, June.
  4. Hongjun Yan, 2010. "Is Noise Trading Cancelled Out by Aggregation?," Management Science, INFORMS, INFORMS, vol. 56(7), pages 1047-1059, July.
  5. Sekkel, Rodrigo, 2011. "International evidence on bond risk premia," Journal of Banking & Finance, Elsevier, Elsevier, vol. 35(1), pages 174-181, January.
  6. Daniel Andrei & Bruce Carlin & Michael Hasler, 2014. "Model Disagreement and Economic Outlook," NBER Working Papers 20190, National Bureau of Economic Research, Inc.
  7. Roman Muraviev, 2013. "Market selection with learning and catching up with the Joneses," Finance and Stochastics, Springer, Springer, vol. 17(2), pages 273-304, April.
  8. Xavier Gabaix, 2012. "Variable Rare Disasters: An Exactly Solved Framework for Ten Puzzles in Macro-Finance," The Quarterly Journal of Economics, Oxford University Press, vol. 127(2), pages 645-700.
  9. Christensen, Peter Ove & Larsen, Kasper & Munk, Claus, 2012. "Equilibrium in securities markets with heterogeneous investors and unspanned income risk," Journal of Economic Theory, Elsevier, Elsevier, vol. 147(3), pages 1035-1063.
  10. Philippe Mueller & Andrea Vedolin & Hao Zhou, 2011. "Short Run Bond Risk Premia," FMG Discussion Papers, Financial Markets Group dp686, Financial Markets Group.
  11. Jaksa CVITANIC & Semyon MALAMUD, 2010. "Price Impact and Portfolio Impact," Swiss Finance Institute Research Paper Series, Swiss Finance Institute 10-26, Swiss Finance Institute.
  12. Leonid Kogan & Stephen Ross & Jiang Wang & Mark M. Westerfield, 2009. "Market Selection," NBER Working Papers 15189, National Bureau of Economic Research, Inc.
  13. Ingrid Lo & Stephen Sapp, 2011. "Belief Dispersion and Order Submission Strategies in the Foreign Exchange Market," Working Papers, Bank of Canada 11-8, Bank of Canada.
  14. Wei Xiong, 2013. "Bubbles, Crises, and Heterogeneous Beliefs," NBER Working Papers 18905, National Bureau of Economic Research, Inc.
  15. Jianfeng Yu, 2011. "A sentiment-based explanation of the forward premium puzzle," Globalization and Monetary Policy Institute Working Paper, Federal Reserve Bank of Dallas 90, Federal Reserve Bank of Dallas.
  16. Harrison Hong & David Sraer, 2012. "Quiet Bubbles," NBER Working Papers 18547, National Bureau of Economic Research, Inc.
  17. Dan Cao, 2011. "Collateral Shortages, Asset Price and Investment Volatility with Heterogeneous Beliefs," Working Papers, Georgetown University, Department of Economics gueconwpa~11-11-01, Georgetown University, Department of Economics.
  18. Ming Pu & Gang-Zhi Fan & Seow Ong, 2012. "Heterogeneous Agents and the Indifference Pricing of Property Index Linked Swaps," The Journal of Real Estate Finance and Economics, Springer, Springer, vol. 44(4), pages 543-569, May.

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