Utility-Weighted Forecasting and Calibration for Risk-Adjusted Decisions under Trading Frictions

TL;DR

This paper introduces a utility-weighted calibration method for financial forecasting that accounts for trading frictions, significantly improving decision loss and risk-adjusted returns in empirical tests.

Contribution

It develops a calibration criterion aligned with decision loss under trading frictions and demonstrates its effectiveness in reducing decision loss and improving risk-adjusted performance.

Findings

Reduces realized decision loss by over 30%

Improves Sharpe ratio from -3.62 to -2.29

Decreases frequency of binding constraints from 16.0% to 5.1%

Abstract

Forecasting accuracy is routinely optimised in financial prediction tasks even though investment and risk-management decisions are executed under transaction costs, market impact, capacity limits, and binding risk constraints. This paper treats forecasting as an econometric input to a constrained decision problem. A predictive distribution induces a decision rule through a utility objective combined with an explicit friction operator consisting of both a cost functional and a feasible-set constraint system. The econometric target becomes minimisation of expected decision loss net of costs rather than minimisation of prediction error. The paper develops a utility-weighted calibration criterion aligned to the decision loss and establishes sufficient conditions under which calibrated predictive distributions weakly dominate uncalibrated alternatives. An empirical study using a pre-committed nested walk-forward protocol on liquid equity index futures confirms the theory: the proposed utility-weighted calibration reduces realised decision loss by over 30\% relative to an uncalibrated baseline ($t$-stat -30.31) for loss differential and improves the Sharpe ratio from -3.62 to -2.29 during a drawdown regime. The mechanism is identified as a structural reduction in the frequency of binding constraints (from 16.0\% to 5.1\%), preventing the "corner solution" failures that characterize overconfident forecasts in high-friction environments.