Heterogeneous Expectations and Bond Markets

Abstract

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 on speculative positions against each other and therefore generate endogenous relative wealth fluctuation. The relative wealth fluctuation amplifies asset price and contributes to the time variation in bond premia. Our model shows that a modest amount of heterogeneous expectations 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. The Author 2009. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please email: journals.permissions@oxfordjournals.org, Oxford University Press.