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Heterogeneous Expectations and Bond Markets

  • Wei Xiong
  • Hongjun Yan
  • Review Financial

This paper presents a dynamic equilibrium model of bond markets in which two groups of agents hold heterogeneous expectations about future economic conditions. The heterogeneous expectations cause agents to take speculative positions against each other and therefore generate endogenous relative wealth fluctuation. The relative wealth fluctuation amplifies asset price volatility and contributes to the time variation in bond premia. Our model shows that a modest amount of heterogeneous expectation can help explain several puzzling phenomena, including the "excessive volatility" of bond yields, the failure of the expectations hypothesis, and the ability of a tent-shaped linear combination of forward rates to predict bond returns.

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File URL: http://icfpub.som.yale.edu/publications/2614
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Paper provided by Yale School of Management in its series Yale School of Management Working Papers with number amz2614.

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Date of creation: 01 Jan 2007
Date of revision: 01 Jun 2009
Handle: RePEc:ysm:somwrk:amz2614
Contact details of provider: Web page: http://icf.som.yale.edu/

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