Importance of Transaction Costs for Asset Allocations in FX Markets
109 Pages Posted: 24 Mar 2018 Last revised: 24 Mar 2020
Date Written: December 12, 2019
Taking transaction costs into account in a mean-variance portfolio optimization in FX markets significantly improves the after cost Sharpe ratio out-of-sample. The optimization reduces trading costs and turnover, whereas the before cost performance remains unchanged. Rules-of-thumb to reduce costs – such as (i) construct equally weighted strategies, (ii) trade at a low frequency, (iii) restrict trading to low cost assets, (iv) only rebalance if the current position is far from the desired position, or (v) use expected returns net of costs in the optimization – are inefficient as there are adverse effects on the (before cost) performance which dominate the cost savings.
Keywords: Transaction Costs, Mean-Variance, Optimization, Asset Allocation, Foreign Exchange, Carry Trade
JEL Classification: F31, G11, G15
Suggested Citation: Suggested Citation