What is the net interest rate differential (NIRD)?
The net interest rate differential (NIRD) in international currency markets is the difference in interest rates for two distinct economic regions. For example, if a trader is long on the NZD / USD pair, he or she owns the New Zealand currency and borrows the US currency. These New Zealand dollars can be placed in a New Zealand bank while simultaneously taking out a loan of the same amount with the American bank. The net interest rate differential is the difference between any interest earned and any interest paid while maintaining the currency pair position.
Generally, an interest rate differential (IRD) measures the contrast in interest rates between two similar interest-bearing assets. Forex traders use interest rate differentials when setting forward exchange rates. On the basis of interest rate parity, a trader can create an expectation of the future exchange rate between two currencies and fix the premium, or discount, on futures contracts on current market exchange rates. The net interest rate differential is specific to use in the currency markets.
The net interest rate differential explained
The net interest rate differential is a key element of the carry trade. A carry trade is a strategy that currency traders use to try to take advantage of the difference in interest rates, and if traders are a currency pair for a long time, they can benefit from a rise in the currency pair. While the carry trade earns interest on the net interest rate differential, a change in the underlying currency pair spread could easily fall (as it always has) and risk losing the benefits carry trade resulting in losses.
Currency trading remains one of the most popular trading strategies in the currency market. The best way to start by carrying out a carry trade is to determine which currency offers a high return and which offers a lower return. The most popular carry operations are to buy currency pairs like AUD / JPY and NZD / JPY, as these have generally very high interest rate spreads.
Example of differential net interest rate trading
The NIRD is the amount the investor can expect to achieve by using a carry trade. Suppose an investor borrows $ 1,000 and converts the funds to pounds, which allows him to buy a British bond. If the bond purchased earns 7% and the equivalent American bond yields 3%, then the IRD is equal to 4%, or 7% minus 3%. This profit is only guaranteed if the exchange rate between dollars and pounds remains constant.
One of the main risks associated with this strategy is the uncertainty of currency fluctuations. In this example, if the pound fell against the US dollar, the trader could suffer losses. In addition, traders can use leverage, such as a factor of 10 to 1, to improve their profit potential. If the investor has multiplied his borrowing by a factor of 10 to 1, he could make a profit of 40%. However, leverage could also result in significant losses in the event of significant exchange rate fluctuations.