The profitability of carry trade: a GCC perspective
Creators: name: Al-Ali, Musaed
Publisher: name: RMIT University
Year: 2024

description: Carry trade is a strategy that takes advantage of interest rate differentials between currencies. The literature has shown that this strategy is very rewarding, generating similar returns to the S&amp;P 500 with a better Sharpe ratio. The success of carry trade is a result of the failure of uncovered interest rate parity (UIP), where UIP states that currencies with a high interest rate should depreciate against currencies with low interest rates by the interest rate differential. The literature has documented that currencies with high interest rates tend to appreciate against low interest rate currencies, contradicting UIP. This failure, results in double gains for carry traders one of them being the interest rate differential and the other is the gains from any exchange rate movement.<br><br>The literature shows that the use of emerging countries’ currencies in carry trade would lead to an improvement in returns. The research examines the validity of this conclusion by conducting carry trades using the currencies of the Gulf Cooperation Council (GCC) against the currencies of developed countries’. The results obtained from this research are consistent with literature, showing positive returns when emerging countries’ currencies were used.<br><br>In 1983, Meese and Rogoff published a paper concluding that no forecasting model can outperform the naïve random walk. Since then a comprehensive body of literature dedicated to unravelling what is known as the Meese-Rogoff “puzzle” has been unsuccessful in overturning these results. For a long time it was widely accepted that exchange rate models cannot outperform a naïve random walk in forecasting. However the Meese-Rogoff results can be overturned by using measures of forecasting accuracy other than those that depend on the magnitude of the forecasting error. The results presented in this study imply that the random walk can be outperformed in terms of profitability.<br><br>Carry traders conduct the strategy assuming that exchange rates move in a random walk manner. Enhancing the process by embedding a forecasting element into the procedure led to an improvement in returns and a reduction in risk. The results from this research were in line with Meese and Rogoff findings that no forecasting model can overcome the random walk in terms of magnitude of error. But at the same time, results showed that the forecasting model used in the research produced better returns and standard deviation. This would indicate that our forecasting model outperformed the random walk in terms of returns, risk, and risk-adjusted returns.<br><br>Carry traders assume that exchange rates move in a driftless random walk manner. This assumption is proven to be correct, but only in the short term. This study examines the 36 currency pairs under investigation and finds that there are statistically significant drifts in many of them. Taking these statistically significant drifts into account when determining the carry trade position leads to an improvement in both profitability and risk. The results are also consistent with literature, showing that conducting the strategy using portfolios would lead to an improvement in returns and risk reduction.