Differences in beliefs and currency risk premia

This paper investigates how heterogeneous beliefs of professional investors impact on the currency options market. 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 our 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, even in the absence of short-selling constraints.