Importance of Transaction Costs for Asset Allocations in FX Markets

109 Pages Posted: 24 Mar 2018 Last revised: 24 Mar 2020

See all articles by Thomas Andreas Maurer

Thomas Andreas Maurer

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

Luca Pezzo

University of New Orleans

Mark P. Taylor

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

Date Written: December 12, 2019

Abstract

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

Maurer, Thomas Andreas and Pezzo, Luca and Taylor, Mark Peter, Importance of Transaction Costs for Asset Allocations in FX Markets (December 12, 2019). Available at SSRN: https://ssrn.com/abstract=3143970 or http://dx.doi.org/10.2139/ssrn.3143970

Thomas Andreas Maurer

The University of Hong Kong ( email )

Pokfulam Road
Hong Kong, Pokfulam HK
Hong Kong

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

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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