Journal
JOURNAL OF FINANCIAL ECONOMICS
Volume 98, Issue 3, Pages 415-438Publisher
ELSEVIER SCIENCE SA
DOI: 10.1016/j.jfineco.2010.07.001
Keywords
Option pricing; Difference in beliefs; Incomplete markets; Foreign exchange
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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. Using a unique data set with detailed information on foreign-exchange forecasts, we construct an empirical proxy for differences in beliefs. We show that this proxy has a strong effect on the implied volatility of currency options beyond the volatility of macroeconomic fundamentals. We document that differences in beliefs impact also on the shape of the implied volatility smile, on the volatility risk-premiums, and on future currency returns. (C) 2010 Elsevier B.V. All rights reserved.
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