I am trying to calculate a historical daily series of developed market currency returns versus the USD, which can be used in backtesting currency strategies. In real time, one would buy a currency forward at a certain tenor, say 3 months, and then roll this forward until it was time to close it out at which case profit would be the forward rate minus the current spot.

How would one construct a historical return series which simulates trading in the forward market? I thought one way would be to pick a tenor (say 3 months), and on each day see what the realized spot rate was 3 months later versus the current forward exchange rate, so that the profit is the difference between the two. However, this seems unrealistic as the forward can be closed out at any time.

Another way would be to try to simulate the value of the forward contract for a given tenor at each point in time, perhaps by using a covered interest parity like condition?

  • $\begingroup$ When I test, I use FX futures prices from the Chicago Merc precisely because they automatically incorporate interest rate parities. However, there are only limited # of currencies traded at CME, and perhaps you are interested in other ones. The alternative is to have 3 time series: the spot rate, the domestic overnight rate and the foreign overnight rate, and calculate returns from those. $\endgroup$ – Alex C May 5 '18 at 1:23

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