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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.

We study the economic value of market timing in foreign exchange (FX) markets, that is, using information about the conditional Sharpe ratio to adjust the notional value of a conditionally mean–variance efficient currency portfolio. Our strategy trades more (less) aggressively when the conditional risk-return trade-off is more (less) favorable. This leads to a significant improvement in the out-of-sample unconditional Sharpe ratio, skewness, and maximum drawdown per 1% expected excess return. The strategy’s market timing predicts returns, volatility, and skewness in FX markets. Popular currency pricing factors do not explain the strategy’s high average excess returns. Our findings suggest that it is costly to impose leverage or risk (i.e., conditional volatility) limits or other inferior market timing policies when constructing currency trading strategies.

We introduce the concept of risk entanglement in a preference-free setting to jointly explain the exchange rate volatility, cyclicality, and currency risk premia in the data. Risk entanglement specifies a subset of incomplete market models, in which nondiffusive or nonlog-normal shocks to exchange rates are not fully spanned by asset returns. When risks are entangled, there exist multiple pricing-consistent exchange rates, but none of them are equal to the ratio of the stochastic discount factors (SDFs) or their projections. Decoupling the exchange rate from the SDFs allows us to address key FX market patterns that are puzzling in international finance.

From a private banking practitioner to a scholar, Dr. Maurer is a romantic man driven by interests instead of gold. Keen on knowledge sharing, Dr. Maurer hopes that he could induce positive impacts on students.