Interest rate differential
| Interest rate differential |
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| See also |
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)[1]. 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[2].
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[3].
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[4]
Examples of Interest rate differential
- Interest rate differential is used to calculate the cost of carry, or the cost of borrowing one currency to purchase another. For example, a trader may borrow U.S. dollars to purchase euros, and the cost of carrying the position is the difference between the interest rates for the two currencies.
- Interest rate differential is also used to determine the cost of hedging a foreign exchange exposure with a currency forward contract. For example, a company may have a foreign currency earnings exposure, and can hedge this exposure by entering into a forward contract. The cost of the hedge is the interest rate differential between the two currencies.
- Interest rate differentials are also used to calculate the expected return on an investment in a foreign currency. For example, an investor may purchase a bond denominated in euros. The expected return on the investment would be the interest rate on the euro bond minus the interest rate on a comparable U.S. bond.
Advantages of Interest rate differential
Interest rate differential (IRD) can be a beneficial tool for investors looking to maximize their returns. It can be used to exploit discrepancies in interest rates between currencies to generate profits through arbitrage. Here are some advantages of using interest rate differential:
- By taking advantage of discrepancies in interest rates, investors can maximize their returns through arbitrage. This involves buying a currency with a higher interest rate and selling one with a lower interest rate, thereby gaining the difference in returns.
- IRD can be used to hedge against potential losses in other investments. By taking out a loan in one currency with a higher interest rate and investing in another currency with a lower interest rate, investors can offset any losses in their other investments.
- Investors can use IRD to diversify their portfolios. By investing in multiple currencies with different interest rates, investors can reduce their risk exposure and spread out their investments.
- IRD can also be used to take advantage of different economic cycles. By investing in currencies with higher interest rates during periods of economic growth, and taking out loans in currencies with lower interest rates during periods of economic downturn, investors can take advantage of different economic cycles and maximize their returns.
Limitations of Interest rate differential
Interest rate differential (IRD) is a percentage difference between interest rates of two similar financial instruments in pair. Though IRD is commonly used to determine the cost and profitability of a transaction, it has some limitations to consider. The following is a list of some of the most common limitations of IRD:
- IRD does not take into account the changes in the exchange rate of the two currencies, which can significantly affect the cost of the transaction.
- IRD does not consider the differences in credit risk associated with the two currencies, which can also affect the cost of a transaction.
- IRD does not account for the transaction costs associated with a currency exchange, such as fees and commissions.
- IRD does not include any opportunities for arbitrage or other market anomalies that may exist in the foreign exchange market.
- IRD assumes interest rates remain constant, but in reality, interest rates are constantly changing, which can affect the cost of a transaction.
- IRD does not consider the liquidity of the two currencies, which can also affect the cost of a transaction.
Interest rate differential (IRD) is a percentage difference between interest rates of two similar financial instruments in pair. There are several other approaches related to interest rate differential, which include:
- Forward Rate Bias (FRB) – FRB is a phenomenon in which the forward rate of a certain currency pair is observed to be higher or lower than the expected spot rate at the time the forward rate is set.
- Carry Trade – Carry Trade is a trading strategy in which investors borrow funds in a low-interest-rate currency and then invest the borrowed funds in a higher-yielding currency.
- Interest Rate Parity (IRP) – IRP states that the differences in interest rates between two countries should be equal to the differences in their exchange rates.
- Cross Currency Basis Swap – Cross Currency Basis Swap is a type of transaction in which two parties exchange two different currencies with different interest rates.
In summary, there are several approaches related to interest rate differential, including Forward Rate Bias, Carry Trade, Interest Rate Parity, and Cross Currency Basis Swap. Each of these approaches can be used to generate profits from currency movements.
Footnotes
References
- Ahmad S., (2011) The Integration of Financial Markets in GCC Countries The Pakistan Development Review, 50(3),p. 209-218.
- Blejer, Mario I., (1982). “Interest Rate Differentials and Exchange Risk (Recent Argentine Experience) Staff Papers (International Monetary Fund), vol. 29, no. 2, pp. 270–279.
- Fenton P., Paquet A., (1998) International Interest Rate Differentials:The Interaction with Fiscal and Monetary Variables, and the Business Cycle CREFE Université du Québec à Montréal, No. 56
- Madura J., Fox R., (2007) International Financial Management Thomson Learning, London
- Moles P., Terry N., (1997) Handbook of International Financial Terms" Oxford University Press,
- Russell J., (2018) Understanding Interest Rate Differentials
- Scott Hacker R. and others (2010) The Relationship between Exchange Rate and Interest Rate Differentials - a Wavelet approach CESIS Electronic Working Paper Series, No. 217
Author: Arkadiusz Liszka
