DP7392 Dynamic Trading with Predictable Returns and Transaction Costs

Author(s): Nicolae Bogdan Garleanu, Lasse Heje Pedersen
Publication Date: August 2009
Keyword(s): dynamic trading, portfolio choice, predictability, transaction costs
JEL(s): G11, G12
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=7392

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.