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.

This paper examines how much speculative trade can be sustained in an economy when CRRA-utility agents have heterogeneous beliefs about aggregate consumption disasters but can walk away from their  financial commitments. We find that that little or no speculative trade can be sustained in an economy without pledgeable income when agents are reasonably risk averse. In autarchy, the disaster risk premia are set by the pessimists. However, even small bailout subsidies in the disaster state may be sufficient to sustain lots of speculative trade, in turn inducing low disaster risk premia.