The profitability of carry trade

The profitability of carry trade is investigated using six currency combinations and historical data covering the period December 1999-June 2006. Hypothesis testing and Monte Carlo simulations produce results that cast doubt on the profitability of carry trade, as there is mostly a fifty-fifty chance that profit can be made from a single carry trade operation. The results also show that carry trade is not an exclusively yen-based operation, in the sense that currency combinations not involving the yen can be as profitable as combinations involving the yen. Because the interest rate differential is not the only factor determining the profitability of carry trade, a proper criterion for selecting the underlying positions must embody both the interest rate differential and exchange rate volatility. It is concluded that over-enthusiasm about carry trade is a reflection of herd behaviour.