What Is an Interest Rate Differential?
In general, an interest rate differential (IRD) weighs the contrast in interest rates between two similar interest-bearing assets. Traders in the foreign exchange market use IRDs when pricing forward exchange rates.
Based on the interest rate parity, a trader can create an expectation of the future exchange rate between two currencies and set the premium, or discount, on the current market exchange rate futures contracts.
KEY TAKEAWAYS
Interest rate differentials simply measure the difference in interest rates of two different instruments.
IRD is most often used in fixed income, forex, and lending markets.
IRD plays a key role in calculating a carry trade.
Understanding Interest Rate Differential
Interest rate differentials simply measure the difference in interest rates between two securities. If one bond yields 5% and another 3%, the IRD would be 2 percentage points. IRD calculations are most often used in fixed income trading, forex trading, and lending calculations.
The interest rate differential is used in the housing market to describe the difference between the interest rate and a bank's posted rate on the prepayment date for mortgages. The IRD is a key component of the carry trade. A carry trade is a strategy that foreign exchange traders use in an attempt to profit from the difference between interest rates, and if traders are long a currency pair, they may be able to profit from a rise in currency pair.
Interest Rate Differential: A Trade Example
The IRD is the amount the investor can expect to profit using a carry trade. Say an investor borrows $1,000 and converts the funds into British pounds, allowing for the purchase of a British bond. If the purchased bond yields 7% while the equivalent U.S. bond yields 3%, then the IRD equals 4%, or 7% - 3%. This profit is ensured only if the exchange rate between dollars and pounds remains constant.
One of the primary risks involved with this strategy is the uncertainty of currency fluctuations. In this example, if the British pound were to fall in relation to the U.S. dollar, the trader may experience losses.
Additionally, traders may use leverage, such as a factor of 10-to-1, to improve their profit potential. If the investor leveraged the borrowing by a factor of 10-to-1, they could make a profit of 40%. However, leverage could also cause larger losses if there are strong movements in exchange rates.
Interest Rate Differential: A Mortgage Example
When homebuyers borrow money to purchase houses, there may be an interest rate differential. For example, say a homebuyer purchased a home and took out a mortgage at a rate of 5.50% for 30 years. Assume 25 years have passed and the borrower only has five years left in the mortgage term. The lender could use the current market interest rate it is offering for a five-year mortgage to determine the interest rate differential. If the current market interest rate on a five-year mortgage is 3.85%, the interest rate differential is 1.65% or 0.1375% per month.
The Difference Between IRD and Net Interest Rate Differential (NIRD)
The net interest rate differential (NIRD) is a specific type of IRD used in Forex markets. In international currency markets, the NIRD is the difference in the interest rates of two distinct economic regions.
For instance, if a trader is long the NZD/USD pair, they would own the New Zealand currency and borrow the US currency. These New Zealand dollars can be placed into a New Zealand bank while simultaneously taking out a loan for the same amount from the U.S. bank. The net interest rate differential is the difference in any interest earned and any interest paid while holding the currency pair position.
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