What is the 'Interest Rate Differential - IRD'
The interest rate differential (IRD) is a differential measuring the gap in interest rates between two similar interest-bearing assets. Traders in the foreign exchange market use interest rate differentials (IRD) 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.
BREAKING DOWN 'Interest Rate Differential - IRD'
The interest rate differential is also 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 profit from a rise in currency pair.
Interest Rate Differential Trade Example
For example, say an investor borrows $1,000 and converts the funds into British pounds, allowing him to purchase 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%. The IRD is the amount the investor can expect to profit using a carry trade. 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 his borrowing by a factor of 10-to-1, he could make a profit of 40%. However, leverage could also cause large losses if there are large movements in exchange rates.
Interest Rate Differential 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 his 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.