Ambiguity, Nominal Bond Yields, and Real Bond Yields
- American Economic Review: Insights (Forthcoming)
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.
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