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Optimal transaction filters under transitory trading opportunities: Theory and empirical illustration

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  • Balvers, Ronald
  • Wu, Yangru

Abstract

If transitory profitable trading opportunities exist, transaction filters mitigate trading costs. We use a dynamic programming framework to design an optimal filter that 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. For daily dollar-yen exchange trading, 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 transaction costs. However, when the optimal filter is used, returns after costs remain positive and higher than for naïve filters.

Suggested Citation

  • Balvers, Ronald & Wu, Yangru, 2010. "Optimal transaction filters under transitory trading opportunities: Theory and empirical illustration," Journal of Financial Markets, Elsevier, vol. 13(1), pages 129-156, February.
    • Handle: RePEc:eee:finmar:v:13:y:2010:i:1:p:129-156
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    2. Kozhan, Roman & Salmon, Mark, 2012. "The information content of a limit order book: The case of an FX market," Journal of Financial Markets, Elsevier, vol. 15(1), pages 1-28.

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    More about this item

    Keywords

    Transaction costs Transaction filters Trading strategies Foreign exchange;

    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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