Foreign exchange market efficiency and commercial loan rates

In an efficient speculative market prices should fully reflect information available to market participants and it should be impossible for a trader to earn excess returns to speculation. Academic interest in foreign exchange market efficiency can be traced to arguments concerning the information content of financial market prices and the implications for social efficiency. In its simplest form, the efficient markets hypothesis can be reduced to a joint hypothesis that foreign exchange market participants are, in an aggregate sense (a) endowed with rational expectations and (b) risk-neutral. The hypothesis can be modified to adjust for risk, so that it then becomes a joint hypothesis of a model of equilibrium returns (which may admit risk premia) and rational expectations.
If the risk-neutral efficient markets hypothesis holds, then the expected foreign exchange gain from holding one currency rather than another - the expected exchange rate change -must be just offset by the opportunity cost of holding funds in this currency rather than the other - the interest rate differential. This condition, generally referred to as the uncovered interest rate parity (UIP) condition, represents the cornerstone parity condition for testing foreign exchange market efficiency:
 
where S_t denotes the logarithm of the spot exchange rate (domestic price of foreign cur¬rency) at time t, i_t and i* are the nominal interest rates available on similar domestic and foreign securities respectively (with k periods to maturity), ∆_kS_t+k = S_t+k - S_t, and the superscript e denotes the market expectation based on information at time t. Most often, however, discussions of foreign exchange market (commercial loan rates) efficiency have taken place in the context of the relationship between spot and forward exchange rates. Implicitly, researchers have used a link between spot and forward rates and interest rates, known as covered interest rate parity. Prior to discussing the uncovered interest rate parity condition in detail, therefore, we shall first examine covered interest rate parity.