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202CHAPTER 6. FOREIGN EXCHANGE MARKET EFFICIENCYForeign Exchange Market Efficiency Summary1. The Þnancial market is said to be efficient if there are no unexploitedexcess proÞt opportunities available. What is excessivedepends on a model of market equilibrium. Violations of uncoveredinterest parity in and of themselves does not mean that theforeign exchange market is inefficient.2. The Lucas model–perhaps the most celebrated asset pricingmodel of the last 20 years–provides a qualitative and elegantexplanation for why uncovered interest parity doesn’t hold. Thereason is that risk-averse agents must be compensated with arisk premium in order for them to hold forward contracts in arisky currency. The forward rate becomes a biased predictor ofthe future spot rate because this risk premium is impoundedinto the price of a forward contract. But the Lucas model requireswhat many people regard as an implausibly coefficient ofrelative risk aversion to generate sufficiently large and variablerisk premia to be consistent with the volatility of exchange ratereturns data.3. Analyses of survey data from professional foreign exchange marketparticipants predictions of future exchange rates Þnd thatthe survey forecast error is systematic. If you believe the surveydata, these systematic prediction errors may be the reason thatuncovered interest parity doesn’t hold.4. Market participant’s systematic forecast errors can be consistentwith rationality. A class of models called ‘peso-problem’models show how rational agents make systematic predictionerrors when there is a positive probability that the underlyingstructure may undergo a regime shift.5. On the other hand, it may be the case that some market participantsare indeed irrational in the sense that they believe thatpseudo signals are important determinants of asset returns. Thepresence of such noise traders generate equilibrium asset pricesthat deviate from their fundamental values.