Interest Rate Differential

Interest rate differential (IRD) can be defined as the difference between the interest rates of two similar interest-bearing assets or investments. It can measure to what extent two investments differ. The concept is particularly used in stock trading, foreign exchange markets, bank mortgages, etc.

IRD can help investors select the assets they want to invest in. Since investing and trading is about profits, investors constantly monitor the IRD and avoid a negative one. Similarly, individuals can look into the differences between mortgage interest rates and make better borrowing decisions in the housing market.

• Interest rate differential (IRD) is the direct difference between the percentage interest rates of two similar investments.
• IRD is mostly looked for in the forex market, real estate, and carry trade.
• It can aid in comparing two investments or mortgage options by trying to maximize profits or minimize cost/ loss. Thus, it enables better decision-making.
• Net interest rate differential (NIRD) can be described as a type of IRD, where the former implies the difference in interests between two countries. Hence, there is a correlation between interest rate differential and exchange rate.

Interest rate differential as a finance concept has gained prominence, especially after the economic changes in the twenty-first century's first decade. Thus, people became aware of the negative IRD potentially affecting their profits.

But why is there a difference between interest rates? Firstly, this can be due to the difference in the risk factor of the investments. The risk of investment affects the returns. Secondly, the nature of the asset is another factor. The interest rate differs depending on the type of security – bond, stock, etc.

Thirdly, market imperfections and inefficiencies can alter the interest rate. This often depends on the economic situation of the country. Lastly, interest rate, like price, is influenced by supply and demand. This can also be why two similar investments differ in interest rates.

Now, let's discuss the role of IRD. First, there is a strong relationship between interest rate differential and exchange rate. More specifically, the NIRD affects currency trading. Secondly, it is also seen in mortgage interest rates and is most evident throughout the mortgage.

Finally, the role of IRD can be seen in stock trading when two similar assets offer different interest rates. Specifically, it is used in the carry trade, a strategy in which investors borrow at low-interest rates, later investing in a high-return asset.

Let's discuss the interest rate differential formula:

IRD = Interest rate of 1st investment – Interest rate of 2nd investment

The computation is rather simple, and many online tools like an interest rate differential calculator help investors or borrowers easily calculate the difference. 

Now, let's look at some examples.

#1 - Bond

The best example would be the comparison of EUR/ USD. Suppose John has $500 with him. He converts it into Euro and buys the stock of a German company, X. The interest rate of the investment is expected to be 9%. If John instead invested in a US company, Q using the dollars, the interest rate on that investment would've been 8%.

Hence, the IRD here is,

(Interest rate)1 – (Interest rate)2

= 9% - 8% 

= 1%

#2 - Mortgage

The second example is that of the housing market. Suppose Jane bought a house for $300,000. The interest rate on borrowing was 7.5%, with a loan term of 20 years. In 10 years, Jane calculates the interest rate offered by the bank for a ten-year mortgage, which is 6%.

One can calculate the IRD as,

= 7.5% - 6%

= 1.5%

The main difference between IRD and NIRD is that the former is used in the context of forex markets, stock trading, housing markets, etc. On the other hand, NIRD is used to find the gap between the interest rate in two countries. Hence, NIRD is used in the context of forex markets and concerns the currencies.

NIRD is studied in depth by traders and finance experts to understand the variance in interest rates and how they can affect the returns on investment. However, essentially, both compare the variance in interest rates – assets or investments, mortgage interest rates, etc.

This has been a guide to What is Interest Rate Differential. We explain it with calculations & examples & compare it with the net interest rate differential. You may also find some useful articles here -

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