Standard asset pricing theories have difficulty explaining episodes that are not simply linked to fundamentals. Notable examples in the dynamics of capital markets are the equity premium puzzle or the excess volatility puzzle.

These puzzles have motivated an increasingly large literature over the last couple of decades that explores the general equilibrium implications of uncertainty for asset prices. This paper studies the importance of heterogeneous beliefs for the dynamics of asset prices.

The focus here is on currency markets, where the absence of short-selling constraints allowed the researchers to perform sharper tests of theoretical predictions. Both option and underlying markets were examined so that a richer array of empirical implications can be studied, including 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, an empirical proxy for differences in beliefs was constructed. The evidence demonstrates that a process related to the uncertainty about fundamentals has important asset pricing implications.

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