How do foreign-exchange transaction costs and dealer markups typically affect retail returns on exotic currencies?
Executive summary
Retail returns on exotic currencies are routinely and materially reduced by transaction costs and dealer markups because exotic pairs are illiquid, exhibit wide bid–ask spreads and heavy price impact when traded; scholarly work shows these frictions can turn otherwise profitable strategies into losers and that cost-aware portfolio construction or hedging is often required to preserve returns [1] [2].
1. Why “exotic” means more cost, not more free money
Exotic currencies trade in thinner, less deep markets than majors, which translates into wider quoted bid–ask spreads and larger price impact when an investor transacts; academic analysis finds proportional costs measured by quoted spreads are meaningful but the price impact of trading—how much the market moves against the trader as liquidity is consumed—can be the dominant drain on returns for many currency strategies [1].
2. How dealer markups and explicit fees bite retail P&L
Dealer markups show up in two ways: explicit fees and commissions charged by banks or brokers, and implicit markups embedded in wider spreads and execution slippage; fee guides and accounting references note that both explicit fees and realized exchange losses must be tracked separately because each reduces net proceeds from a conversion [3], and research underscores that these embedded and explicit costs materially lower realized returns when converting or trading exotic currency positions [1].
3. Which strategies are most vulnerable
High-turnover or volume-sensitive strategies—carry trades, momentum plays, and mean–variance optimized currency portfolios—are especially vulnerable because they require frequent rebalancing into less-liquid currencies; the ScienceDirect study shows that once price-impact costs are included many such strategies quickly become unprofitable and that when assets under management grow large (the paper cites an AUM threshold around USD 660 million) price impact dominates returns [1].
4. The interaction with currency moves and business exposures
Beyond trading frictions, currency moves themselves amplify the effect of costs: foreign currency returns add or subtract to investment performance, and a stronger or weaker domestic currency can swing returns in either direction, meaning that trading costs compound market-driven gains or losses; practitioners therefore treat transaction exposure and hedging as distinct considerations because the underlying exchange-rate moves remain a primary driver of returns even after costs are applied [2] [4].
5. Mitigation: cost-aware design and hedging matter
Empirical work suggests the only reliable defenses are reducing turnover in illiquid pairs, using cost-optimized portfolio algorithms that keep positions “close enough” to an optimal weighting to minimize trading, and hedging or using instruments that internalize FX exposure; the same study documents a cost-optimized portfolio that remains profitable out-of-sample and is robust to severe price-impact conditions [1], while practical guides recommend hedging with forwards or options to isolate business cash flows from raw spot-market slippage [5].
6. What the data and reporting do not settle
While academic and practitioner sources agree that transaction costs and dealer markups materially erode retail returns in exotic FX, the available reporting here does not provide standardized, up-to-date retail-level numbers for typical spreads or markups across specific exotic currency pairs, nor a catalog of broker fee schedules; therefore any concrete estimate of “how much” retail returns fall must be drawn from specific broker quotes or execution data rather than these general studies [1] [3].