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162CHAPTER 6. FOREIGN EXCHANGE MARKET EFFICIENCYthe data. The ensuing challenge is then to understand why uncoveredinterest parity fails.We cover three possible explanations. The Þrst is that the forwardforeign exchange rate contains a risk premium. This argumentis developed using the Lucas model of chapter 4. The second explanationis that the true underlying structure of the economy is subject tochange occasionally but economic agents only learn about these structuralchanges over time. During this transitional learning period inwhich market participants have an incomplete understanding of theeconomy and make systematic prediction errors even though they arebehaving rationally. This is called the ‘peso-problem’ approach. Thethird explanation is that some market participants are actually irrationalin the sense that they believe that the value of an asset dependson extraneous information in addition to the economic fundamentals.The individuals who take actions based on these pseudo signals arecalled ‘noise’ traders.The notational convention followed in this chapter is to let uppercase letters denote variables in levels and lower case letters denote theirlogarithms, with the exception of interest rates, which are always denotedin lower case. As usual, stars are used to denote foreign countryvariables.6.1 Deviations From UIPLet s be the log spot exchange rate, f be the log one-period forwardrate, i be the one-period nominal interest rate on a domestic currency(dollar) asset and i ∗ is the nominal interest rate on the foreign currency(euro) asset. If uncovered interest parity holds, i t − i ∗ t =E t (s t+1 ) − s t ,but by covered interest parity, i t −i ∗ t = f t −s t . Therefore, unbiasednessof the forward exchange rate as a predictor of the future spot ratef t =E t (s t+1 ) is equivalent to uncovered interest parity.We begin by covering the basic econometric analyses used to detectthese deviations.