Ambiguity, Nominal Bond Yields, and Real Bond Yields

Abstract

This paper presents an equilibrium bond-pricing model that jointly explains the upward-sloping nominal and real yield curves and the violation of the expectations hypothesis. Instead of relying on the inflation risk premium, the ambiguity-averse agent faces different amounts of Knightian uncertainty in the long run versus the short run; hence, the model-implied nominal and real short rate expectations are upward sloping under the agent’s worst-case equilibrium beliefs. The expectations hypothesis roughly holds under investors’ worst-case beliefs. The difference between the worst-case scenario and the true distribution makes realized excess returns on long-term bonds predictable. (JEL D81, D84, E23, E31, E43, E44, G12)

Learning, Equilibrium Trend, Cycle, and Spread in Bond Yields

“…The common equilibrium explanation for the upward-sloping nominal yield curve is the inflation risk premium (Piazzesi and Schneider, 2007), where inflation is bad news for future growth and the agent prefers an early resolution to the uncertainty. Zhao (2020) shows that this approach was less effective during the past two decades when inflation switched from bad news to good news for future growth, providing an alternative worstbetween short-run inflation and growth expectations. case belief approach through ambiguity.…”

“…case belief approach through ambiguity. We show that model II can be extended by incorporating the intuition discussed in Zhao (2020). The ambiguity-averse representative agent (with the recursive multiple priors, or maxmin, preferences in Epstein and Schneider 2003) has in mind a benchmark or reference measure of the economy's dynamics that represents the best estimate of the stochastic process.…”

“…However, short-run inflation and growth expectations moved in opposite directions pre-2000, which makes it hard for model II to generate an average upward-sloping nominal curve (the short-run expectations and, hence, the yield spreads are stationary and mean zero). We therefore rely on the worst-case belief approach (Zhao, 2020) to generate upward-sloping nominal and real curves that are consistent with the data.…”

“…This paper is related to a number of papers that study the implications of ambiguity and robustness for finance and macroeconomics. 7 Model III incorporates the intuition in Zhao (2020) to generate the upward-sloping nominal and real curves through the upwardsloping short-rate expectations under the representative agent's worst-case belief. Finally, this paper is also related to some recent developments wherein the implications of learning in finance were investigated.…”

“…7 Recent papers that study the multiple-priors preference and its applications include Epstein and Schneider (2007), Ilut (2012), Ilut and Schneider (2014), Ulrich (2013) , Gagliardini et al (2009), Bianchi et al (2017), Ilut et al (2018), Zhao (2017), andZhao (2020), among many others. Papers on robustness applications include Anderson, Hansen, andSargent (2003), Cagetti, Hansen, Sargent, andWilliams (2002), Hansen (2007), and Sargent (2001, 2010).…”