Importance of Transaction Costs for Asset Allocation in Foreign Exchange Markets

Ilias Filippou, Thomas Maurer, Luca Pezzo and Mark Taylor

No 19037, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: Transaction costs have a first-order effect on the performance of currency portfolios. Proportional costs based on quoted bid-ask spread are relatively small, but when a fund is large, costs due to the trading volume price impact are sizable and quickly erode returns, leaving many popular strategies unprofitable. A mean-variance-transaction-cost optimized approach (MVTC) that accounts for costs in the optimization efficiently tackles the problem with only relatively minor negative implications on before-cost profitability. MVTC is robust even when the price impact of trading is severe. Finally, we introduce an accurate extrapolation approach to expand the sample of the realized Amihud measure of Ranaldo and Santucci de Magistris (2022) from 12 to 26 currencies and from 2012 back in time to 1986.

Keywords: Transaction costs; Price impact; Realized Amihud; Asset allocation; Foreign exchange; Carry trade (search for similar items in EconPapers)
JEL-codes: F31 G11 G15 (search for similar items in EconPapers)
Date: 2024-05
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Journal Article: Importance of transaction costs for asset allocation in foreign exchange markets (2024)
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