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Importance of Transaction Costs for Asset Allocations in FX Markets Explained

Last Updated on 10 February, 2024 by Rejaul Karim

The paper “Importance of Transaction Costs for Asset Allocations in FX Markets” presents a groundbreaking exploration of the pivotal role of transaction costs in mean-variance portfolio optimization within FX markets.

Authored by Thomas Andreas Maurer, Luca Pezzo, and Mark P. Taylor, this research delves into the profound impact of taking transaction costs into consideration, enhancing the after-cost Sharpe ratio in an out-of-sample context.

The optimization not only mitigates trading costs and turnover but also preserves the before-cost performance. The study challenges prevalent rules-of-thumb regarding cost reduction, demonstrating their inefficacy in light of adverse effects on the before-cost performance, which outweigh the cost savings.

With its focus on transaction costs, mean-variance optimization, asset allocation, foreign exchange, and the carry trade, this research charts a path towards redefining asset allocation strategies in FX markets.

Abstract Of Paper

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.

Original paper – Download PDF

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Author

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); Brookings Institution

Conclusion

In conclusion, the study on the “Importance of Transaction Costs for Asset Allocations in FX Markets” offers groundbreaking insights into the dynamics of mean-variance portfolio optimization within FX markets.

Authored by Thomas Andreas Maurer, Luca Pezzo, and Mark P. Taylor, this research underscores the substantial improvement in after-cost Sharpe ratio in an out-of-sample context when transaction costs are factored into the optimization.

Notably, the optimization not only curtails trading costs and turnover but also maintains the before-cost performance. It challenges prevalent cost-reduction rules-of-thumb, revealing their inefficacy due to adverse effects on the before-cost performance, which overshadow the cost savings.

With its focus on transaction costs, mean-variance optimization, asset allocation, foreign exchange, and the carry trade, this research holds profound implications for reshaping asset allocation strategies in FX markets, thereby enriching the understanding of transaction cost dynamics in investment decisions.

Related Reading:

Market Timing and Predictability in FX Markets

Diversification Effect of Standard and Optimized Carry Trades

FAQ

Q1: What is the main focus of the research paper “Importance of Transaction Costs for Asset Allocations in FX Markets”?

A1: The main focus of the research paper is to explore the importance of transaction costs in mean-variance portfolio optimization within FX (foreign exchange) markets. The study investigates the impact of considering transaction costs on the after-cost Sharpe ratio in an out-of-sample context.

Q2: How does taking transaction costs into account affect mean-variance portfolio optimization in FX markets, according to the research?

A2: Taking transaction costs into account in mean-variance portfolio optimization within FX markets significantly improves the after-cost Sharpe ratio in an out-of-sample context. The optimization helps in reducing trading costs and turnover while maintaining the before-cost performance of the portfolio.

Q3: What are the findings regarding rules-of-thumb for reducing costs in the context of FX markets?

A3: The research challenges prevalent rules-of-thumb for reducing costs in FX markets, such as constructing equally weighted strategies, trading at a low frequency, restricting trading to low-cost assets, only rebalancing if the current position is far from the desired position, or using expected returns net of costs in the optimization. The study suggests that these rules-of-thumb are inefficient as they can have adverse effects on the before-cost performance, which may outweigh the cost savings.

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