Dynamic Trading with Predictable Returns and Transaction Costs

Lasse Pedersen and Nicolae Bogdan Garleanu

No 7392, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: This paper derives in closed form the optimal dynamic portfolio policy when trading is costly and security returns are predictable by signals with different mean-reversion speeds. The optimal updated portfolio is a linear combination of the existing portfolio, the optimal portfolio absent trading costs, and the optimal portfolio based on future expected returns and transaction costs. Predictors with slower mean reversion (alpha decay) get more weight since they lead to a favorable positioning both now and in the future. We implement the optimal policy for commodity futures and show that the resulting portfolio has superior returns net of trading costs relative to more naive benchmarks. Finally, we derive natural equilibrium implications, including that demand shocks with faster mean reversion command a higher return premium.

Keywords: Dynamic trading; Portfolio choice; Predictability; Transaction costs (search for similar items in EconPapers)
JEL-codes: G11 G12 (search for similar items in EconPapers)
Date: 2009-08
New Economics Papers: this item is included in nep-mst
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (8)

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Related works:
Journal Article: Dynamic Trading with Predictable Returns and Transaction Costs (2013)
Working Paper: Dynamic Trading with Predictable Returns and Transaction Costs (2009)
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