One rate here, another there:the gap between is what pairs compare.
The difference in interest rates between two countries whose currencies form a pair.
Interest rate differentials drive carry trades and significantly influence currency valuations.
In plain words
Each currency has an interest rate behind it, set largely by its central bank. The interest rate differential is the gap between the rates of the two currencies in a pair.
See it move
Differential: the distance between Higher rate and Lower rate
Why it matters
The differential is the basis of the swap, the amount credited or charged for holding a position overnight, and of the carry trade, which holds a higher-rate currency against a lower-rate one. Changes in the expected differential are also commonly associated with movements in the exchange rate.
Worked example
An example only. The figures are round and invented for the arithmetic: they are not market prices.
Currency A has an interest rate of 5% and currency B a rate of 1%, and a position is worth 100,000.
- 1Differential5% − 1% = 4% a year
- 2On the position100,000 × 0.04 = 4,000 a year
- 3Per day4,000 ÷ 365 ≈ 10.96
Before any adjustment by a broker, the differential is worth about 11 a day on this position, credited or charged according to its direction.
A common mistake
A favourable differential is not income without risk. The exchange rate can move against the position by more than the interest earned, and a broker’s swap usually includes a markup, so the credit is smaller than the raw differential and can even be a charge.
Check yourself
Educational information, not investment advice or a recommendation to trade.