Download this Paper Open PDF in Browser

Differences in Beliefs and Currency Risk Premia

48 Pages Posted: 27 Feb 2007 Last revised: 15 Dec 2009

Alessandro Beber

Cass Business School; Centre for Economic Policy Research (CEPR)

Francis Breedon

University of London, Queen Mary - School of Economics and Finance

Andrea Buraschi

The University of Chicago; Imperial College Business School; Centre for Economic Policy Research (CEPR)

Date Written: December 8, 2009

Abstract

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

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

Alessandro Beber (Contact Author)

Cass Business School ( email )

London, EC2Y 8HB
Great Britain

Centre for Economic Policy Research (CEPR) ( email )

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

Francis Breedon

University of London, Queen Mary - School of Economics and Finance ( email )

Mile End Road
London, E1 4NS
United Kingdom

Andrea Buraschi

The University of Chicago ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States
7738347123 (Phone)

HOME PAGE: http://www.andreaburaschi.com/

Imperial College Business School ( email )

South Kensington Campus
Exhibition Road
London SW7 2AZ, SW7 2AZ
United Kingdom

HOME PAGE: http://www.andreaburaschi.com/

Centre for Economic Policy Research (CEPR)

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

Paper statistics

Downloads
264
Rank
97,217
Abstract Views
1,205