Abstract
This paper examines the profitability of using the United Arab Emirates dirham as a U.S. dollar pegged currency in carry trade. Carry trade is a speculative currency strategy that takes advantage of interest rate differential between two currencies. Literature has shown that such strategy generates returns that are almost similar to that of the S&P 500 but with double its Sharpe ratio. Results of this study show that implementing such strategy using pegged currencies produced positive returns and these results were improved when the selection process was enhanced with forecasting element.
Highlights
Carry trade is a simple strategy that is conducted by all levels of investors from sophisticated sovereign wealth funds to simple housewives
The empirical results presented in this paper are based on six currency combinations involving the Emirates dirham (AED) against the Japanese yen (JPY), the British pound (GBP), the Korean won (KRW), the Singaporean dollar (SGD), the Canadian dollar (CAD), and the Swiss franc (CHF)
The most improvement came in Arab Emirates dirham (AED)/KRW where the return improved from -0.64% under carry trade to 10.83% under the forecasting-based strategy
Summary
Carry trade is a simple strategy that is conducted by all levels of investors from sophisticated sovereign wealth funds to simple housewives. Fair (2008) describes exchange rate equations as “not the pride of open economy macroeconomics” and argues that the “general view still seems pessimistic” Researchers such as Leitch and Tanner (1991), Chow et al (2007) and Moosa (2013) questioned the rationale behind buying forecasting models by profit-maximising firms since measures of forecasting accuracy indicate that the random walk produces better forecasts for free. Engle and Hamilton (1990) supported the use of direction accuracy, by describing it as “not a bad proxy for a utility-based measure of forecasting performance” It has been documented by Eun and Sabherwal (2002) that the majority of the banks they examine show some evidence of outperforming the random walk on the profitability side. It has been documented by Eun and Sabherwal (2002) that the majority of the banks they examine show some evidence of outperforming the random walk on the profitability side. Moosa (2013) suggests that profitability is the ultimate test of forecasting accuracy
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