Importance of Transaction Costs for Asset Allocations in FX Markets

56 Pages Posted: 24 Mar 2018 Last revised: 26 Jul 2018

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: April 21, 2018

Abstract

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

Maurer, Thomas Andreas and Pezzo, Luca and Taylor, Mark Peter, Importance of Transaction Costs for Asset Allocations in FX Markets (April 21, 2018). 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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