Disappointment Aversion, Term Structure, and Predictability Puzzles in Bond Markets

We solve a dynamic equilibrium model with generalized disappointment-aversion preferences and continuous state-endowment dynamics. We apply the framework to the term structure of interest rates and show that the model generates an upward-sloping term structure of nominal interest rates and a downward-sloping term structure of real interest rates and that it accounts for the failure of the expectations hypothesis. The key ingredients are preferences with disappointment aversion, preference for early resolution of uncertainty, and an endowment economy with three state variables: time-varying macroeconomic uncertainty, time-varying expected inflation, and inflation uncertainty. This paper was accepted by Karl Diether, finance.