Importance of Transaction Costs for Asset Allocations in FX Markets
91 Pages Posted: 24 Mar 2018 Last revised: 16 Mar 2019
Date Written: March 13, 2019
Taking transaction costs into account in a mean-variance portfolio optimization in FX markets significantly improves the out-of-sample Sharpe ratio (after costs) from 0.75 to 0.96. The optimization reduces trading costs while the performance before costs is unaffected. The price impact due to large buy and sell orders or market illiquidity can turn popular currency trading strategies unprofitable, while our optimized portfolio remains profitable. Finally, rules-of-thumb to tackle transaction costs –such as (i) construct equally weighted strategies instead of optimized portfolios, (ii) trade at a low frequency, or (iii) restrict trading to low cost assets – are not efficient.
Keywords: Transaction Costs, Mean-Variance, Optimization, Asset Allocation, Foreign Exchange, Carry Trade
JEL Classification: F31, G11, G15
Suggested Citation: Suggested Citation