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 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)

Is Noise Trading Cancelled Out by Aggregation?

“…However, the underlying argument can also be taken further to analyze asset price dynamics. For example, Xiong and Yan (2010) show that the impact of independent biases can shed light on a series of stylized facts on the bond price behavior. Moreover, the meanreversion implication from my model might have contributed to the long-run reversal in stock returns that has been documented in De Bondt and Thaler (1985).…”

“…If biases about the aggregate consumption growth were introduced, they would induce interesting dynamics of the interest rates. See Xiong and Yan (2010) for a recent analysis of the impact of disagreement on the term structure of interest rates.…”

“…Moreover, the underlying argument can be taken further to analyze asset price dynamics. For example, Xiong and Yan (2010) analyze a model in which investors have biased beliefs but their average belief coincides with the rational belief. The wealth fluctuation induced by biases can explain a number of stylized facts about bond prices (e.g., the high volatility of long-term bond yields and the strong time variation in bond return premium).…”

Fear or fundamentals? Heterogeneous beliefs in the European sovereign CDS market

“…Xiong and Yan (2010) introduce disagreement between two types of agents about future economic conditions to explain several stylized facts in the bond markets. They find that bond yield volatility is increased due to the changes in wealth of the two speculating parties.…”

Biology-induced effects on investor psychology and behavior

“…While much of the latter phenomena might generally be unsystematic in the overall marketplace, variation in demographics as well as systematic social and economic conditions can certainly affect aggregate risk aversion levels and hence market risk premiums through the influence. In addition, the findings that greater heterogeneity in expectations can influence risk premiums required in the market by impacting price volatility (Xiong & Yan, 2009) indicate a further factor that could impact the level of optimism in the market. 6 The intrinsic cyclicity of the real economy also contributes to this looping feedback effect and can even be the catalyst for them.…”