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Differences in beliefs and currency risk premiums

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  • Beber, Alessandro
  • Breedon, Francis
  • Buraschi, Andrea

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. 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.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Financial Economics.

Volume (Year): 98 (2010)
Issue (Month): 3 (December)
Pages: 415-438

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Handle: RePEc:eee:jfinec:v:98:y:2010:i:3:p:415-438

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Web page: http://www.elsevier.com/locate/inca/505576

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Keywords: Option pricing Difference in beliefs Incomplete markets Foreign exchange;

References

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Citations

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Cited by:
  1. Yu, Jianfeng, 2013. "A sentiment-based explanation of the forward premium puzzle," Journal of Monetary Economics, Elsevier, vol. 60(4), pages 474-491.
  2. Riccardo Colacito & Mariano M. Croce, 2012. "International Robust Disagreement," American Economic Review, American Economic Association, vol. 102(3), pages 152-55, May.
  3. Fong, Wai Mun, 2013. "Footprints in the market: Hedge funds and the carry trade," Journal of International Money and Finance, Elsevier, vol. 33(C), pages 41-59.
  4. Jeremy Graveline & Irina Zviadadze & Mikhail Chernov, 2012. "Crash Risk in Currency Returns," 2012 Meeting Papers 753, Society for Economic Dynamics.

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