Interest Rate Differential - IRD

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DEFINITION of 'Interest Rate Differential - IRD'

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 IRD is a key component of the carry trade. For example, say an investor borrows US$1,000 and converts the funds into British pounds, allowing the investor to purchase a British bond. If the purchased bond yields 7% while the equivalent U.S. bond yields 3%, then the IRD equals 4% (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.

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