The interest rate differential (IRD) refers to the difference in interest rates between two similar interest-bearing currencies in the foreign exchange market. In the spot foreign exchange market, this pertains to the difference in interest rates in a pair.
For example, if the Australian dollar has an interest rate of 4.50% and the Japanese yen has an interest rate of 0.10%, then the interest rate differential between the two is 4.40%.
The IRD is one of the most important factors to consider when engaging in carrying trade.
Generally, a lender will use the IRD if the interest rate on a homebuyer’s mortgage is higher than their current interest rate, or they signed the mortgage less than five years ago. It is a tool for lending institutions to make up the lost payments they could have gained on the funds had they lent them elsewhere.
It is essential for every homebuyer, especially those who receive a cash windfall and are thinking about paying off their mortgage early. The IRD is often passed along as a fee to mitigate the opportunity cost of a bank potentially having to loan out the money that accrues a lower interest rate.
Interest rate differentials are also used to calculate future currency exchange rates and understand the premium or discount futures hold to current market rates. Simply put, it measures the differences in interest rates.