Question

Forward Rate as an Unbiased Predictor:

Some forecasters believe that foreign exchange markets for the major floating currencies are "efficient" and forward exchange rates are unbiased predictors of future spot exchange rates. What is meant by "unbiased predictor" in terms of the reliability of the forward rate in estimating future spot exchange rates?

Answer 1

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.

An unbiased predictor is a 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 marketor changing economic conditions, especially 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.

Because forward rates theoretically reflect all available information, they then become unbiased

predictors of futures spot rates.