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Optimal Transaction Filters under Transitory Trading Opportunities: Theory and Empirical Illustration

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Author Info
Ronald J. Balvers (Department of Economics, West Virginia University)
Yangru Wu (Department of Finance and Economics, Rutgers University)

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Abstract

If transitory profitable trading opportunities exist, filter rules are used to mitigate transaction costs. We use a dynamic programming framework to design an optimal filter which maximizes after-cost expected returns. The filter size depends crucially on the degree of persistence of trading opportunities, transaction cost, and standard deviation of shocks. Applying our theory to daily dollar-yen exchange trading, we find that the optimal filter can be economically significantly different from a naïve filter equal to the transaction cost. The candidate trading strategies generate positive returns that disappear after accounting for transaction costs. However, when the optimal filter is used, returns after costs remain positive and are higher than for naïve filters.

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File URL: http://www.be.wvu.edu/div/econ//work/pdf_files/04-12.pdf
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File Function: First version, August 23, 2004
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Publisher Info
Paper provided by Department of Economics, West Virginia University in its series Working Papers with number 04-12.

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Length: 46 pages
Date of creation: 2004
Date of revision:
Handle: RePEc:wvu:wpaper:04-12

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Related research
Keywords: Transaction Costs; Filter Rules; Trading Strategies; Foreign Exchange;

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Find related papers by JEL classification:
G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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    Other versions:
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  18. Marquering, Wessel & Verbeek, Marno, 2004. "The Economic Value of Predicting Stock Index Returns and Volatility," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 39(02), pages 407-429, June. [Downloadable!]
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