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Heterogeneous Expectations and Bond Markets

  • Wei Xiong
  • Hongjun Yan

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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