UNCOVERED INTEREST PARITY AND THE EFFICIENCY OF THE FOREIGN EXCHANGE MARKET: A RE-EXAMINATION OF THE EVIDENCE

this paper, we find that the traditional approach to testing UIP is misleading because of the significant difference in volatility between the change in the log of the exchange rates and the forward premium, and also because of the presence of conditional heteroskedasticity in the data. This difference has an effect on the estimates of the relevant slope parameter and on the estimates of the uncertainty about the parameter. We show by means of a bootstrap simulation experiment that the econometric rejections of UIP can be spurious and that an alternative methodology is needed to test for foreign exchange markets efficiency. We introduce a set of more direct and economically meaningful profitability-based tests of market efficiency based on UIP. Our results are far more favourable than the existing literature to foreign exchange market efficiency. Copyright (C) 2010 John Wiley & Sons, Ltd.