What Is an Unbiased Predictor?
An unbiased predictor refers to a financial theory that spot prices at some future date will be equal to today's forward rates. However, it does not take into account any risk premiums demanded by the market or changing economic conditions, especially interest rates.
Also called the unbiased expectations hypothesis or expectations theory.
How Unbiased Predictors Work
In statistical terms, "bias" is generally considered to be the variance between a prediction and the actual outcome, so an unbiased predictor is one that, one average, closely forecasts the future behavior of the variable under consideration. For example, if a futures contract is considered an unbiased predictor of oil prices, then when the contract expires the price of oil should correspond with the anticipated price.
The unbiased predictor, or expectations theory, states that long-term interest rates hold a forecast for short-term interest rates in the future. The theory postulates that an investor earns the same amount of interest by investing in a one-year bond in the present and rolling the investment into a different one-year bond after one year as compared to purchasing a two-year bond in the present.
In some instances, the expectations theory is utilized as an explanation for the yield curve. However, the theory has been shown to be inaccurate in execution, because interest rates typically stay flat when the yield curve is normal. Essentially, the expectations theory is known to over-estimate future short-term interest rates.
In the currency markets, an unbiased predictor is the theory that forward exchange rates for delivery at a specific date in the future are equal to the spot rates in effect for that date. Again, in practice, the theory fails due to the lack of adjustment for a risk premium. Therefore, the unbiased expectations really do not occur in actual trading.
Further, the unbiased predictor is independent of market conditions, which are dynamic and ever changing.
A forward rate is an interest rate applicable to a financial transaction that will take place in the future. Forward rates are calculated from the spot rate and are adjusted for the cost of carry to determine the future interest rate that equates the total return of a longer-term investment with a strategy of rolling over a shorter-term investment. It may also refer to the rate fixed for a future financial obligation, such as the interest rate on a loan payment.
In the currency markets, the forward rate specified in an agreement is a contractual obligation that must be honored by the parties involved. Exchange rates between two countries depend on their respective interest rates.
Because forward rates theoretically reflect all available information, they then become unbiased predictors of futures spot rates.
Again, "all available information" is subject to change over time as new information becomes available.