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Ambiguity, Nominal Bond Yields and Real Bond Yields

Guihai Zhao

Staff Working Papers from Bank of Canada

Abstract: Equilibrium bond-pricing models rely on inflation being bad news for future growth to generate upward-sloping nominal yield curves. We develop a model that can generate upward-sloping nominal and real yield curves by instead using ambiguity about inflation and growth. Ambiguity can help resolve the puzzling fact that upward-sloping yield curves have persisted despite positive inflation shocks changing from negative to positive news about growth in the last twenty years. Investors make decisions using worst-case beliefs, under which the expectations hypothesis roughly holds. However, inflation and growth evolve over time under the true distribution, and this difference makes excess returns on long-term bonds predictable. The model is also consistent with the recent empirical findings on the term structure of equity returns.

Keywords: Asset Pricing; Financial markets; Interest rates (search for similar items in EconPapers)
JEL-codes: G00 G12 E43 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-mac
Date: 2018
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Persistent link: https://EconPapers.repec.org/RePEc:bca:bocawp:18-24

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