Importance of Transaction Costs for Asset Allocations in FX Markets
56 Pages Posted: 24 Mar 2018 Last revised: 26 Jul 2018
Date Written: April 21, 2018
Taking transaction costs into account in a mean-variance portfolio optimization significantly improves the out-of sample performance. Using FX market returns of 29 currencies from 1976 to 2016, we document that the out-of-sample Sharpe Ratio after costs is 0.7 for a portfolio which ignores transaction costs in the optimization (MV), while it is 0.9 for a portfolio which accounts for costs in the optimization (MV-TC). The difference is due to a substantial reduction in transaction costs paid by MV-TC compared to MV, while the performance before transaction costs is almost identical across the two strategies. Correctly accounting for the correlation between assets is important. A portfolio that accounts for transaction costs but assumes assets are uncorrelated has a Sharpe ratio of 0.76, which is statistically significantly smaller than the Sharpe ratio of MV-TC.
Keywords: Transaction Costs, Mean-Variance, Optimization, Asset Allocation, Foreign Exchange, Carry Trade
JEL Classification: F31, G11, G15
Suggested Citation: Suggested Citation