Interest rate differential
|Interest rate differential|
Interest rate differential (IRD) - is a percentage difference between interest rates of two similar financial instruments in pair (e.g. one currency is traded with an interest rate of 5 percent, and second currency has an interest rate of 4 percent, what gives 1 percent interest rate differential). It is used mainly in foreign exchange market for pricing purposes.
Application of IRD
Calculation of interest rate differential is most often used in:
- Forex trading
- Fixed income trading
- Lending calculations.
- Futures and forward contracts calculation
In the mortgage market, interest rate differential reflects the difference between the interest rate and a rate posted by bank on the prepayment date for mortgages. FOREX traders use IRD in carry trade to make profit on currency pairs. When there is a rise in a currency pair, traders that have long positions on that pair are able to make a profit.
Covered interest arbitrage
IRD plays a major role in the mechanism of Covered interest arbitrage, which is the process of capitalizing on interest rate differential between two countries with covering exchange rate risk. It can be split into two parts: "interest arbitrage" and "covered"."Interest arbitrage" is a process of capitalizing on the difference between the interest rates of two countries, while "covered" reflects hedging the position against exchange risk, by securing the fixed forward exchange rate for the transaction.
Interest rate differential and spot exchange rate
Interest rate differential is strongly linked with the terms of exchange rate and inflation . On the short time scale there is a negative relationship between the spot exchange rate (domestic-currency price of foreign currency) and the nominal interest rate differential (approximately the domestic interest rate minus the foreign interest rate, but on the long time scales the relationship is positive. Increasing the home country’s interest rate (not due to money supply reduction), will lower money demand in that country and drive up its aggregate demand, what leads to rise of inflation, and the exchange rate.
Interest rate differential and forwards
In the pricing the forward rate, which is basically the price of an outright forward contract, is calculated on the spot rate at the real, with correction for forward points which represents the interest rate differential between the two currencies taken into consideration
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Author: Arkadiusz Liszka