Dynamic term structure with heterogeneous beliefs

This dissertation demonstrates that one possible economic explanation of the dynamics of the term structure is the time-varying heterogeneous beliefs about future economic conditions. Assuming a large number of agents holding diverse beliefs about both his income shocks and others' beliefs about their income shocks, it derives a closed-form equilibrium solution which demonstrates that heterogeneous beliefs about future state variables generate time-varying risk premia of the term structure. Motivated by this theory, several empirical tests are conducted using the cross-sectional mean and dispersion of belief indices that are extracted as the differences between professional forecasts and non-judgemental econometric forecasts based on a large macro information set. It first estimates two sets of linear models using belief indices and their underlying variables as factors to explain the term structure dynamics. It is found that an increase in the mean belief about inflation significantly steepens the yield curve and the mean belief about federal funds rate best predicts excess holding period returns among single factors. Then a non-linear bivariate VAR is explored with beliefs about interest rates driving the drift and the volatility of the short rate and the spread. It is shown that both the mean and dispersion of interest rate beliefs help explain the mean and the stochastic volatility of the term structure, suggesting that time-varying risk premia may be explained by endogenous uncertainty caused by heterogeneous beliefs about the future conditions of the economy.