Dynamic Trading with Predictable Returns and Transaction Costs

45 Pages Posted: 8 Dec 2009

See all articles by Garleanu Nicolae

Garleanu Nicolae

affiliation not provided to SSRN

Lasse Heje Pedersen

AQR Capital Management, LLC; Copenhagen Business School - Department of Finance; New York University (NYU); Centre for Economic Policy Research (CEPR)

Date Written: November 2009

Abstract

This paper derives in closed form the optimal dynamic portfolio policy when trading is costly and security returns are predictable by signals with dierent mean-reversion speeds. The optimal updated portfolio is a linear combination of the existing port- folio, the optimal portfolio absent trading costs, and the optimal portfolio based on future expected returns and transaction costs. Predictors with slower mean reversion (alpha decay) get more weight since they lead to a favorable positioning both now and in the future. We implement the optimal policy for commodity futures and show that the resulting portfolio has superior returns net of trading costs relative to more naive benchmarks. Finally, we derive natural equilibrium implications, including that demand shocks with faster mean reversion command a higher return premium.

Suggested Citation

Nicolae, Garleanu and Pedersen, Lasse Heje, Dynamic Trading with Predictable Returns and Transaction Costs (November 2009). NYU Working Paper No. 2451/28346, Available at SSRN: https://ssrn.com/abstract=1519257

Garleanu Nicolae

affiliation not provided to SSRN

No Address Available

Lasse Heje Pedersen (Contact Author)

AQR Capital Management, LLC ( email )

Greenwich, CT
United States

Copenhagen Business School - Department of Finance ( email )

Solbjerg Plads 3
Frederiksberg, DK-2000
Denmark

New York University (NYU) ( email )

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

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