what is an interest rate differential ird 
an interest rate differential ird weighs the contrast in interest rates between two similar interest bearing assets most often it is the difference between two interest rates traders in the foreign exchange market use irds 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 understanding interest rate differential ird irds simply measure the difference in interest rates between two securities 1 if one bond yields 5 and another 3 the ird would be 2 percentage points or 200 basis points bps ird calculations are most often used in fixed income trading forex trading and lending calculations the ird is used in the housing market to describe the difference between the interest rate and a bank s posted rate on the prepayment date for mortgages 1the ird is also a key component of the carry trade a trading strategy that involves borrowing at a low interest rate and investing the proceeds in an asset that provides a higher rate of return carry trades often consist of borrowing in a low interest rate currency and then converting the borrowed amount into another currency with a higher yield 2interest rate differential a bond trade examplethe ird is the amount the investor can expect to profit using a carry trade 3 say an investor borrows 1 000 and converts the funds into british pounds allowing for the purchase of a british bond if the purchased bond yields 7 while the equivalent u s bond yields 3 then the ird equals 4 or 7 3 this profit is ensured only if the exchange rate between dollars and pounds remains constant one of the primary risks involved with this strategy is the uncertainty of currency fluctuations 3 in this example if the british pound were to fall in relation to the u s dollar the trader may experience losses additionally traders may use leverage such as a factor of 10 to 1 to improve their profit potential if the investor leveraged the borrowing by a factor of 10 to 1 they could make a profit of 40 however leverage could also cause larger losses if there are strong movements in exchange rates interest rate differential a mortgage example