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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.

Dong Lou has been teaching at the London School of Economics since July 2009. He earned his PhD in Finance from Yale University and a B.S. in Computer Science from Columbia University. His research mostly focuses on understanding market inefficiencies, and their distortionary effects on resource allocation in the real economy. Hongjun Yan is an Associate Professor of Finance at the Yale School of Management. He received his PhD from the London Business School in 2005. The focus of his current research is to better understand the behaviour of asset prices by incorporating bounded rationality, heterogeneous beliefs, reputation, learning and market imperfections etc. into standard asset pricing framework. Jinfan Zhang is currently a PhD candidate in Finance from Yale University. He earned his PhD and B.S. both in Electrical Engineering from Tsinghua University (China). Zhang's research mostly focuses on the institutional origins of asset market liquidity and its impact on asset pricing and financial crisis. Any opinions expressed here are those of the authors and not necessarily those of the FMG. The research findings reported in this paper are the result of the independent research of the authors and do not necessarily reflect the views of the LSE.

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 volatility 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. (JEL D50, D90, G12)

This article analyses the implications of money illusion for investor behaviour and asset prices in a securities market economy with inflationary fluctuations. We provide a belief‐based formulation of money illusion which accounts for the systematic mistakes in evaluating real and nominal quantities. The impact of money illusion on security prices and their dynamics is demonstrated to be considerable even though its welfare cost on investors is small in typical environments. A money‐illusioned investor's real consumption is shown to generally depend on the price level, and specifically to decrease in the price level. A general‐equilibrium analysis in the presence of money illusion generates implications that are consistent with several empirical regularities. In particular, the real bond yields and dividend price ratios are positively related to expected inflation, the real short rate is negatively correlated with realized inflation, and money illusion may induce predictability and excess volatility in stock returns. The basic analysis is generalized to incorporate heterogeneous investors with differing degrees of illusion.