Importance of Transaction Costs for Asset Allocations in FX Markets

91 Pages Posted: 24 Mar 2018 Last revised: 16 Mar 2019

See all articles by Thomas Andreas Maurer

Thomas Andreas Maurer

Washington University in St. Louis - John M. Olin Business School; London School of Economics & Political Science (LSE)

Luca Pezzo

University of New Orleans; Washington University in Saint Louis, John M. Olin Business School, Students

Mark P. Taylor

Washington University in St. Louis - John M. Olin Business School; Centre for Economic Policy Research (CEPR)

Date Written: March 13, 2019

Abstract

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

Maurer, Thomas Andreas and Pezzo, Luca and Taylor, Mark Peter, Importance of Transaction Costs for Asset Allocations in FX Markets (March 13, 2019). Available at SSRN: https://ssrn.com/abstract=3143970 or http://dx.doi.org/10.2139/ssrn.3143970

Thomas Andreas Maurer

Washington University in St. Louis - John M. Olin Business School ( email )

One Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States

London School of Economics & Political Science (LSE) ( email )

Houghton Street
London, WC2A 2AE
United Kingdom

Luca Pezzo (Contact Author)

University of New Orleans ( email )

2000 Lakeshore Drive
New Orleans, LA 70148
United States

Washington University in Saint Louis, John M. Olin Business School, Students ( email )

St. Louis, MO
United States

Mark Peter Taylor

Washington University in St. Louis - John M. Olin Business School ( email )

One Brookings Drive
Campus Box 1156
St. Louis, MO 63130-4899
United States

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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