48 Pages Posted: 27 Feb 2007 Last revised: 15 Dec 2009
Date Written: December 8, 2009
This paper studies the importance of heterogeneous beliefs for the dynamics of asset prices. We focus on currency markets, where the absence of short-selling constraints allows us to perform sharper tests of theoretical predictions. We examine both option and underlying markets, so that we can study a richer array of empirical implications that include both volatility risk premia and expected returns. Using a unique data set with detailed information on the foreign-exchange forecasts of about 50 market participants over more than ten years, we construct an empirical proxy for differences in beliefs. We show that this proxy has a statistically and economically strong effect on the implied volatility of currency options beyond the volatility of current macroeconomic fundamentals. We document that differences in beliefs impact also on the shape of the implied volatility smile, on the volatility risk-premia, and on future currency returns. Our evidence demonstrates that a process related to the uncertainty about fundamentals has important asset pricing implications.
Keywords: Option pricing, difference in beliefs, incomplete markets, foreign exchange
JEL Classification: D9, E3, E4, G12
Suggested Citation: Suggested Citation
Beber, Alessandro and Breedon, Francis and Buraschi, Andrea, Differences in Beliefs and Currency Risk Premia (December 8, 2009). Available at SSRN: https://ssrn.com/abstract=965802 or http://dx.doi.org/10.2139/ssrn.965802
By Jiang Wang