On the Distribution and Estimation of Trading Costs

27 Pages Posted: 4 Aug 2014

See all articles by Apostolos Kourtis

Apostolos Kourtis

University of East Anglia (UEA) - Norwich Business School

Date Written: May 12, 2014

Abstract

This paper investigates the uncertainty about the trading costs associated with a given portfolio strategy. I derive accurate approximations of the ex ante probability distributions of proportional trading costs and portfolio turnover under the conventional assumption of normal asset returns. Based on these approximations, I express the expected trading costs as a function of asset and portfolio characteristics. All else equal, the expected trading costs increase with: i) the deviations of the expected asset returns from the expected portfolio return, ii) the assets' volatility and iii) the portfolio volatility. At the same time, they decrease with the covariance between the assets and the portfolio. Furthermore, I propose novel estimators of the expected turnover and trading costs and show that they offer small bias and low variance, even when the sample size is small. Finally, I incorporate my results into a portfolio selection framework to produce portfolios with low levels of risk and trading costs. Several experiments with real and simulated data confirm the practical value of the results.

Keywords: Portfolio Selection, Rebalancing, Portfolio Turnover, Transaction Costs

JEL Classification: C13, C51, C61, G11

Suggested Citation

Kourtis, Apostolos, On the Distribution and Estimation of Trading Costs (May 12, 2014). Journal of Empirical Finance, 28, 104-117. Available at SSRN: https://ssrn.com/abstract=2465354

Apostolos Kourtis (Contact Author)

University of East Anglia (UEA) - Norwich Business School ( email )

Norwich
NR4 7TJ
United Kingdom

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