What Is an Interest Rate Differential (IRD)?
An interest rate differential (IRD) contrasts the interest rates of two similar interest-bearing assets and represents the difference between them. In the foreign exchange market, the IRD is the difference in the interest rates between two countries and is referred to as the net interest rate differential. IRD calculations are used in fixed-income trading, forex trading, and lending vehicles.
Key Takeaways
- An interest rate differential (IRD) is the difference between the interest rates of two investment vehicles.
- IRD is used in fixed-income, forex, and lending markets.
- Investors who sell currency in a region with a lower interest rate against currency in a country with a higher interest rate can profit from an IRD.
- The net interest rate differential (NIRD) is a specific type of IRD used in forex markets.
Forex Markets
The IRD is a carry trade, atrading strategythat involves borrowing at a low interest rateand investing the proceeds in anassetthat provides a higher rate of return. Carry trades borrow in a low-interest rate currency environment, and convert the borrowed amount into another currency with a higher yield.
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 between the interest rates of two distinct economic regions. For example, if a trader is "long" on the NZD/USD pair, they own the New Zealand currency and borrow the US currency. These New Zealand dollars can be placed into a New Zealand bank while simultaneously borrowing the same amount from the U.S. bank. The NIRD is the difference between any interest earned and interest paid while holding the currency pair position.
Investors profit from theIRD and price appreciation by selling currencies whose country has a lower interest rate against currencies whose country has a higher interest rate. Based on the interest rate parity, a trader predicts the future exchange rate between two currencies and sets the premium, or discount, on current market exchange rate futures contracts.
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Bonds
IRDs measure the difference in interest rates between two securities. If one bond yields 5% and another 3%, the IRD would be 2 percentage points—or 200 basis points (bps). 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%, the IRD equals 4% (7% - 3%).This profit is ensured only if the exchange rate between dollars and pounds remains constant.
The primary risk of this strategy is the uncertainty of currency fluctuations. If the British pound were to fall relative to the U.S. dollar, the trader may experience loss. 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.
Mortgages
When homebuyers borrow money to purchase houses, there may be an IRD. The IRD is used in the housing market to describe the difference between the interest rate and a bank's posted rate on the prepayment date.
Assume a homebuyer purchases a home and takes 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 IRD. If the current market interest rate on a five-year mortgage is 3.85%, the IRD is 1.65% or 0.1375% monthly.
What Are Interest Rate Differential Calculations Used for?
IRD calculations demonstrate the difference in interest rates between two financial securities, usually in fixed-income trading, forex trading, and lending calculations.
How Is Currency Traded on the Forex Market?
Forex exchanges trade 24 hours, five days a week globally. Currencies are traded against one another as pairs like the EUR/USD. Each pair is typically quoted in pips, a percentage in points, out to four decimal places. Currency prices fluctuate based on the economic situation of the countries, global market conditions, and geopolitical instability.
How Is the Interest Rate Differential Used in the Carry Trade?
In carry trade investing, an investor borrows money in a low-interest-rate currency and then converts the amount into a higher-yielding currency. The IRD is the difference between the two interest rates.
The Bottom Line
An interest rate differential (IRD) measures the difference between the interest rates of two financial instruments. The net interest rate differential (NIRD) is the IRD used in forex markets.IRD is used in the fixed-income, forex, and lending markets.
