Interest Rate Differential

A differential measuring the gap in interest rates between two similar interest-bearing assets is called as interest rate differential.

The term interest rate differential (IRD) has multiple usages.

In the mortgage industry, an Interest Rate Differential is used to determine a pre-payment penalty, to account for the excess of the paid-off mortgage’s rate over prevailing rates.

In foreign exchange, the term refers to the practice of borrowing in the currency of a country where interest rates are low and lending the proceeds in the currency of a country where interest rates are higher. The difference in borrowing and lending rates, i.e. the Interest Rate Differential, is anticipated profit.

Applications of Interest Rate Differential in mortgage industry

Prepayment

Pre-payment of a mortgage in the first year usually results in a fee proportionate to the size of the mortgage. Interest rates do not generally change much in one year. The amount lost in future interest collections from a one-year drop in interest rates does not usually approach the usual balance-based first-year pre-payment penalties. Therefore it is reasonable for lenders not to use the IRD as a base for such fees.

After the first year of a mortgage, a pre-payment penalty may be based on the change in interest rates since the loan origination. The remainder of the fixed-rate term (before the loan resets in its ARM phase) would be the basis for determining the bank’s loss. For example, if an ARM resets after five years, and the mortgage is repaid in full after three, the lender would charge for the interest income lost. If the fixed rate was 8 percent and prevailing rates are currently 6 percent, then the lender would charge for the 2 percent difference to be lost over the next two years.

A homeowner that thinks he is taking advantage of prevailing rates in fact may not be, at least for the remainder of the mortgage’s fixed-rate term.

Interest modification

Instead of paying the loan off in full, a homeowner in an ARM may want the interest adjusted before the end of the term. This may be a futile exercise if the bank charges for the interest income to be lost over the subsequent two years. The situation is the same as in a mortgage payoff, trying to recover the drop in interest rates with an up-front fee.

Application of Interest Rate Differential in foriegn excahnge

Forex: Carry Trade Market

The carry trade market, in foreign exchange, is the practice of borrowing in the currency of a country where interest rates are low and lending the proceeds in the currency of a country where interest rates are higher. The Interest Rate Differential determines the profit. This profit is not guaranteed, however, as exchange rates do fluctuate. The practice is also known as uncovered interest arbitrage.

Traders in the foreign exchange market use interest rate differentials (IRD) 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.

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 IRD 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.

Forex: Futures

In interest arbitrage, an exchange-rate fluctuation can effectively cancel out profit from the Interest Rate Differential. Therefore, a forward contract (or future) may be sold to fix the exchange rate for the future repatriation of the second currency to the first. This is called hedged interest arbitrage, and is virtually risk-free, unless a government institutes strong controls that prevent fulfillment of the futures contract or repatriation of the investment returns.