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 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. Investopedia Says:
The interest rate differential 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 interest rate differential equals 4% (7% - 3%). The interest rate differential 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. Related Terms:
Currency Carry Trade
Exchange Rate
Forex - FX
Forex Futures
Interest Rate Parity
Uncovered Interest Rate Parity - UIP |