Job Market Paper

This paper shows how subjective beliefs of large dealer banks help understand the excess volatility in bond markets, the large volatility of long-term interest rates. I document that the interest rate exposures of primary dealers comove systematically with the interest-rate forecasts of their research departments, both in the cross-section of dealers as well as over time. In particular, primary dealers choose higher interest-rate risk exposures when they are more optimistic about the returns on long Treasury bonds relative to short T-bills. I develop and estimate an equilibrium model with dealer banks that have heterogenous interest-rate expectations. The quantitative model shows that the variation in dealers' beliefs about future interest rates is a strong mechanism to explain the volatility of long rates.