Difference in Beliefs and Currency Options Markets

This paper investigates the impact of heterogeneous beliefs of professional investors 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, on the shap e of the implied volatility smile, on the volatility risk-premia, and on future currency returns. We do cument that the volatility of macro economic fundamentals explains only a limited part of the dynamics of difference in beliefs. Furthermore, our findings cannot be explained by overconfidence about priors or about a private signal. Ourevidence demonstrates that a process largely unrelated to macroeconomic fundamentals can have important asset pricing implications.