What Is the Net Interest Rate Differential (NIRD)?
The net interest rate differential (NIRD), in international currency markets, is the difference in the interest rates of two distinct economic regions. For instance, if a trader is long the NZD/USD pair, he or she owns the New Zealand currency and borrows 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.
Generally, an interest rate differential (IRD) measures the contrast in interest rates between two similar interest-bearing assets. Traders in the forex market use interest rate differentials 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. The net interest rate differential is specific to use in currency markets.
The Net Interest Rate Differential Explained
The net interest rate differential 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 the currency pair. While the carry trade does earn interest on the net interest rate differential, a move in the underlying currency pair spread could easily fall (as it has historically) and risk wiping out the benefits of the carry trade leading to losses.
The currency carry trade remains one of the most popular trading strategies in the currency market. The best way to first implement a carry trade is to determine which currency offers a high yield and which offers a lower one. The most popular carry trades involve buying currency pairs like the AUD/JPY and the NZD/JPY, since these have interest rate spreads that are typically very high.
Net Interest Rate Differential Trade Example
The NIRD 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 him to purchase a British bond. If the purchased bond yields 7% and the equivalent U.S. bond yields 3%, then the IRD equals 4%, or 7% minus 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 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.