Dynamic trading with predictable returns and transaction costs

Specialeforsvar: Mathias Dalgaard Stenderup

Titel: Dynamic trading with predictable returns and transaction costs

Abstract: Active investors must consider transaction costs when managing their portfolios. Replicating the results of "Dynamic Trading with Predictable Returns and Transaction Costs" by Gârleanu and Pedersen (2013), we show how to derive an explicit solution for optimal dynamic portfolio choice in the presence of transaction costs and predictable returns. We model transaction costs to be quadratic in trade size and predicted returns as a linear function of return-predicting factors. The analysis reveals that investors must "aim in front of the target" to account for future expected returns and alpha decay of returnpredicting
factors. Investors must trade partially toward the aim, which is shown to be a scaled-down version of the Markowitz portfolio, to obtain maximal portfolio performance net of transaction costs. Using stock-index data from 2009 to 2024, the performance of
the optimal dynamic portfolio is empirically tested against a range of benchmark portfolios. We find evidence that the optimal dynamic portfolio is indeed optimal when tested on in-sample data and when transaction costs are high. These findings highlight
the importance of incorporating transaction costs and predictive dynamics into portfolio optimization.

Vejleder: Rolf Poulsen
Censor:  Kim Christensen, Aarhus Universitet