What Is Interest Differential?

An interest rate differential (IRD) compares the difference in interest rates between two things that pay interest. It’s usually the difference between two rates of interest.

IRDs are used by traders on the foreign exchange market to set prices for forward exchange rates. A trader can guess the future exchange rate between two currencies based on the interest rate parity and set the premium, or discount, on exchange rate futures contracts on the current market.

How to Understand the Interest Rate Differential (IRD)

IRDs are just a way to find the difference between two assets’ interest rates.1. The IRD is two percentage points, or 200 basis points, if one bond yields 5% and another yields 3%. When selling fixed income, forex, or loans, IRD calculations are usually used.

There is a difference between the interest rate and the bank’s reported rate on the date that mortgages are paid off early. This is called the IRD.1

The IRD is also an essential part of the carry trade, which is a way to trade by borrowing money at a low interest rate and investing the money in something with a better rate of return. In carry trades, people often borrow money in a currency with low-interest rates and then exchange that money for another currency with a better yield.2

Differential Interest Rates: An Example of a Bond Trade

The IRD tells investors how much they can expect to make from a carry deal. 3 Let’s say a trader borrows $1,000 and changes it into British pounds so that they can buy a British bond. If the bond that was bought yields 7% and the same-type U.S. bonds yield 3%, then the IRD is 4%, which is 7% – 3%. This return is only guaranteed if the dollar-to-pound exchange rate stays the same.

One of the most significant risks for this approach is that the currency’s value could change.3To use this example, the investor might lose money if the British pound fell against the U.S. dollar.

Traders can also use leverage, like a 10-to-1 number, to increase their profit chances. The investor could make a 40% return if they borrowed money and used it as collateral ten times over. But if there are significant changes in exchange rates, leverage could also lead to more enormous losses.

Differential Interest Rates: An Example of a Mortgage

An IRD may be present when people borrow money to buy homes.

Suppose someone bought a house and got a mortgage of 5.50 percent for 30 years. Suppose 25 years have passed, and the borrower only has five years left on their debt. The interest rate the lender is giving on the market right now for a five-year mortgage could be used to figure out the IRD. If the market rate for a 5-year mortgage is 3.85%, the IRD is 1.65% or 0.1375% per month.4

Difference in Interest Rates (IRD) vs. Difference in Interest Rates (NIRD)

In the forex market, the net interest rate difference (NIRD) is a type of IRD. The NIRD is the difference between the interest rates of two different economic areas in the world’s currency markets.

Let’s say an investor is long the NZD/USD pair. This means they own the New Zealand dollar and borrow the U.S. dollar. You can deposit these New Zealand dollars in a New Zealand bank and borrow the same amount from a U.S. bank simultaneously. What is the NIRD? It is the difference between the interest you made and the interest you paid on the currency pair position.

How do I figure out an interest rate differential?

IRD calculations show the difference in interest rates between two financial assets. They are often used in lending calculations, fixed-income, and forex trading.

What is the difference in interest rates used in the housing market?

This term is used in the housing market to show how the stated interest rate and a bank’s posted rate can differ regarding mortgage due dates.

The interest rate differential is used in the carry trade. How does it work?

In carry trade investing, a person would borrow money in a currency with a low-interest rate and then change that money into a currency with a better yield. The IRD is the difference between the two rates of interest.

Conclusion

• The gap between the interest rates on two instruments is what interest rate differentials (IRDs) are all about.
• Most of the time, IRD is used in trading fixed income, forex, and loans.
• When you do a currency carry deal, IRD is also very important.