Optimal Transaction Filters Under Transitory Trading Opportunities: Theory and Empirical Illustration

HKIMR Working Paper No. 02/2005

36 Pages Posted: 23 Aug 2007

See all articles by Ronald J. Balvers

Ronald J. Balvers

McMaster University - Michael G. DeGroote School of Business

Yangru Wu

Rutgers University, Newark - School of Business - Department of Finance & Economics

Date Written: February 2005

Abstract

If transitory profitable trading opportunities exist, filter rules are used to mitigate transaction costs. We use a dynamic programming framework to design an optimal filter which maximizes after-cost expected returns. The filter size depends crucially on the degree of persistence of trading opportunities, transaction cost, and standard deviation of shocks. Applying our theory to daily dollar-yen exchange trading, we find that the optimal filter can be economically significantly different from a naive filter equal to the transaction cost. The candidate trading strategies generate positive returns that disappear after accounting for transaction costs. However, when the optimal filter is used, returns after costs remain positive and are higher than for naive filters.

Keywords: Transaction Costs, Filter Rules, Trading Strategies, Foreign Exchange

Suggested Citation

Balvers, Ronald J. and Wu, Yangru, Optimal Transaction Filters Under Transitory Trading Opportunities: Theory and Empirical Illustration (February 2005). HKIMR Working Paper No. 02/2005, Available at SSRN: https://ssrn.com/abstract=1009032 or http://dx.doi.org/10.2139/ssrn.1009032

Ronald J. Balvers (Contact Author)

McMaster University - Michael G. DeGroote School of Business ( email )

1280 Main Street West
Hamilton, Ontario L8S 4M4
Canada
(905) 525-9140 x23969 (Phone)

HOME PAGE: http://profs.degroote.mcmaster.ca/business/balvers

Yangru Wu

Rutgers University, Newark - School of Business - Department of Finance & Economics ( email )

1 Washington Park
Newark, NJ 07102
United States
973-353-1146 (Phone)
973-353-1006 (Fax)

HOME PAGE: http://andromeda.rutgers.edu/~yangruwu

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