Interest Rate Differential (IRD)
It refer to the difference in yields or interest rates between two countries, currencies, or economies.
What is an Interest Rate Differential (IRD)?
Interest Rate Differential (IRD) refers to the disparity between the interest rates of two distinct financial instruments or currencies. This difference in interest rates plays a crucial role in various financial transactions and markets, particularly in foreign exchange (forex) trading, bond markets, and lending.
Have you ever thought about why two countries may have different interest rates? This is because of the presence of interest rate differentials. Simply put, interest rate differential (IRD) is the difference between the interest rates of two currencies.
Before diving deep into the concept of interest rate differentials, let us understand the different perspectives from which we can look at interest rates.
The interest rates in the USA currently stand at 5.25%. Think about what this statement means. Which interest rates are we talking about? Here, we are referring to the nominal interest rate in the country.
We have all heard the concept of inflation. If a pen costs $1 today and $2 a year from now, you will be able to purchase lesser pens for ten dollars a year later than today, although your actual income remains the same. In other words, your purchasing power will go down.
The real interest rate does not take inflation into account. Though inflation is not considered, the consumer will still need to be compensated because he is postponing consumption by depositing his money with a bank. This compensation is the real interest rate.
The nominal interest rate is nothing but the real interest rate after considering the effect of inflation. Therefore:
1+ Nominal interest rates = (1+ Real interest rates) * (1 + expected inflation rate)
The central bank will lend money to other commercial banks at this nominal interest rate. Keeping this rate as the benchmark, the country's commercial banks will lend money to customers.
Key Takeaways
- Interest rate differentials (IRD) refer to the difference in yields or interest rates between two countries, currencies, or economies.
- IRD arise due to the differences in the monetary policies of the two countries or currencies.
- IRD are a key component of the forex markets, causing currency appreciation and depreciation.
- The various interest rate parities that deal with currency fluctuations stem from the workings of these differentials.
The Monetary Policy And Interest Rate Differentials
Interest rates are a powerful weapon in the central bank's arsenal that it uses to regulate the money supply in the country. Let us say the economy is overheating. In that case, central banks would increase interest rates so that people refrain from borrowing money.
We know that prices in a country are driven by demand and supply forces. In response to economic conditions, the central bank adjusts its interest rates as a means of regulation.
To implement changes in interest rates, central banks can employ several measures, including
- Raising/lowering interest rates to encourage or discourage borrowing and investment.
- Buying and selling government securities to inject money into or absorb excess money from the economy.
- Altering the reserve requirement by asking commercial banks to deposit more/less money with the central bank to control their lending.
- Increasing/decreasing the interest rate on commercial bank reserves to regulate commercial banks’ money supply.
Demand and supply forces in a country could be affected by various social, political, and demographic factors. Therefore, monetary policies and interest rates across countries will also be different. This discrepancy in interest rates between countries is what we refer to as the interest rate differential.
The term “interest rate” could refer to the interest rate of an individual bond, the interest rates on a loan, or even the interest rates in the money market. However, for our article, the term “interest rate” will refer to the nominal interest rate of a country unless otherwise specified.
Interest Rate Differentials And The Concept Of Carry Trade
To understand the concept of carry trade, let us look at two countries - USA and India. We will take the 1-year treasury bill rates for both of these countries.
According to the federal reserve website, as of July 17, 2023, 1 year T-bill rate is 5.05%. Similarly, according to the Reserve Bank of India, 1 year T-bill rate as of July 7, 2023, is 6.85%.
As a rational investor, how would you seek to exploit the difference in these interest rates? You would look to borrow money in USD (the lower rate) and invest in INR (the higher rate).
We will now look at an example using the above figures to understand the entire process of carry trade.
Let’s say that you borrow $100 today. As of 19th July 2023, the INR/USD exchange rate stands at ₹82.08, i.e., 1 USD is worth 82.08 INR. Since you borrowed $100 and the interest rate is 5.05%, you must repay $105.05 after a year.
For example, if you decide to borrow $100 today, you will have to convert it back to INR using the above exchange rate so you can invest in the Indian markets. Upon conversion, you will have ₹8,208 to invest. This investment will be made in Indian T-bills that would fetch you a return of 6.85%.
After one year, the ₹8,208 you invested will have grown at 6.85%, and your investment is worth ₹8,770.25. Assuming the INR/USD exchange rate on July 19, 2024, is ₹80, you would convert the ₹8,770.25 back to USD, receiving $109.63.
In this carry trade example, you started with an initial sum of $100 and received $109.63 after one year. After repaying the borrowed sum of $105.05, you have made a profit of $4.58. It looks like a good deal, doesn’t it?
Not really. Markets are intelligent enough to prevent investors from exploiting these interest rate differences. This is where the concept of uncovered interest rate parity comes into play.
Why Does The Carry Trade Fail In Practice?
In theory, the carry trade sounds like a pretty sweet deal. Unfortunately, investors cannot use the carry trade to pocket a profit due to the presence of the uncovered interest rate parity. In the coming sections, we will delve into interest rate parity theories in great detail.
Note
The investor cannot use the carry trade - borrow low, invest high - to pocket a profit because the market will correct itself. In other words, the currency of the higher-yield country will depreciate until no profits can be made.
Before taking up an example, let us go through the reasons why the carry trade does not work.
- Currency depreciation: Suppose the investor seeks to make a profit out of interest rate differentials. In that case, the benefit he gets from the higher interest rate will exactly be offset by a depreciation in the currency of the higher-yielding country. There is no scope for profit.
- Efficient financial markets: The most important assumption of the efficient market hypothesis is that it is not possible to beat the market. The market does not give the investor an opportunity to exploit any mispricings.
- Market correction: Though the efficient market hypothesis holds good in the long run, it may be possible for the investor to exploit temporary interest rate differentials and make a profit. However, the market will inevitably correct itself by adjusting exchange rates such that the investor cannot benefit.
Let us continue with the previous example.
| Initial INR/USD exchange rate | ₹82.08 |
| 1 year T-bill rates (USA) | 5.05% |
| 1 year T-bill rates (India) | 6.85% |
| Initial borrowed sum | $100 |
The entire process of carry trade is the same. After one year, the ₹8,208 you invested will have grown at 6.85%, and your investment is worth ₹8,770.25. But here is where the market ensures that the investor cannot make a profit.
Since INR is the higher-yielding currency, it will depreciate against the dollar such that no profit is possible.
The investor is liable to return the borrowed sum of $105.05 (including interest). Our rupee investment currently stands at ₹8,770.25. Therefore, INR will depreciate to ₹83.49. When this happens, converting the sum of ₹8,770.25 will leave the investor with $105.05. Zero profit!
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Interest rate differentials and the Uncovered Interest Rate Parity Theory
We have already studied the reasons behind the practical failure of the carry trade. Remember how the currency of the higher-yield country depreciated until no profits could be made? This is exactly what the uncovered interest rate parity (UIP) theory deals with.
When discussing UIP, we deal with instruments that have not been hedged. In other words, the investor in question has not entered into a forward contract to hedge against exchange rate risk exposure.
UIP theory calculates the expected future spot rate using interest rate differentials. To understand the formula for the UIP theory, let us continue with the same example of USD and INR, as discussed above.
Remember how the market does not allow investors to profit from interest rate differentials? We will apply the same concept here but will now understand it through a formula.
Expected spot rate = Current spot rate * [(1 + Interest ratesUSA)/ (1 + Interest ratesIndia)]
In the previous example, we had the following figures.
| Initial INR/USD exchange rate | ₹82.08 |
| 1 year T-bill rates (USA) | 5.05% |
| 1 year T-bill rates (India) | 6.85% |
Using these figures, we can perform the following calculation.
Expected INR/ USD rate = ₹82.08 * [(1 + 6.85%)/(1 + 5.05%) ]= ₹83.49
From the above calculation, we will get the expected spot rate after one year, i.e., on 19th July 2024, as ₹83.49. This is the exact same figure that we got while calculating the no-profit spot rate in the previous example. This shows that the market adjusts the exchange rate to nullify the potential profits from interest rate differentials.
Note
The above formula deals with one-year spot rates. If you want to calculate spot rates for, say, 90 days, you multiply the interest rates by 90/360 to get the three-month expected spot rates.
Notice how the INR depreciated against the USD. This is because India is a country with a high interest rate. The depreciation of the INR offsets the higher interest rate it offers to investors.
We have now studied the concept of UIP, where forward markets do not come into play. But what if the investor could hedge himself against exchange rate fluctuations? Is there a possibility of a profit?
Hedging Against Exchange Rate Fluctuations
Before discussing covered interest rate parity, we need to understand the concept of hedging against foreign exchange exposure. Let us go through a story to understand this. A, an exporter, is exporting 100 computers from India to the USA. Each computer costs $500.
The current INR/USD exchange rate stands at ₹82.08. If A were selling these goods on a cash basis, there would not be any exchange rate risk exposure as he would receive the money instantly. But A is selling these goods on credit and agrees to receive the money after a year.
At today’s exchange rate, A would have received ₹4.108 million. Since he is selling the goods on credit, he worries that the INR will be appreciated against the USD. Let us say that after a year, the INR/USD rate stands at ₹80. A will only receive ₹4 million.
The more the exchange rate appreciates, the more A will lose. Hence, A will enter into a foreign exchange forward contract to fix the exchange rate after a year to minimize his losses. Let us say that A locks in an INR/USD rate of ₹85.
If the spot rate after one year stands at less than ₹85, A will make a forward gain. Else, he will incur a forward loss. Now that we have understood the concept of foreign exchange hedging let us move on to covered interest rate parity.
Interest rate differentials and the Covered Interest Rate Parity Theory
The Covered Interest Rate Parity (CIP) theory addresses the question of whether an investor can bypass the carry trade and make a profit by locking in an exchange rate through a forward contract.
The primary problem with the carry trade is that the market prices the currency of the higher yield country such that no profit opportunity exists. But what if the investor can lock in an exchange rate?
As we already know, the market is smarter. This is where the concept of the covered interest rate parity (CIP) comes into play. While the UIP deals with calculating the expected spot rate in the future, the CIP is concerned with computing the no-arbitrage forward rate.
The formula for CIP is the same as that of UIP, with one difference. The calculated variable in question is the forward exchange rate at which the investor cannot make a profit.
No arbitrage forward rate = Current spot rate * [(1 + Interest ratesUSA)/ (1 + Interest ratesIndia)]
When we calculate the no-arbitrage forward rate using the same example as we used in UIP, we end up with the same figure of ₹83.49. This is why people often confuse the concept of forward exchange rates and future expected spot rates.
The future expected spot rate is the exchange rate that investors expect the market to come up with after one year. On the other hand, the forward rate is the actual price of a 1-year forward contract. If the investor wishes to enter into a forward contract today, this is the quoted price.
The forward parity theory resolves this confusion. It holds that forward exchange rates derived through CIP would accurately predict expected future spot rates derived from CIP. Hence, both of them should be equal to each other.
Interest Rate Differential (IRD) FAQs
No. Short-term exchange rates are incredibly volatile. We see short-term rates being influenced by investor sentiment, geopolitical risks, and unexpected market events.
In the long run, economic fundamentals such as interest rates will drive exchange rates. So, in the long term, the UIP theory will hold good, and investors cannot profit from interest rate differentials.
However, the CIP theory is based on the concept of no-arbitrage. The market will not allow mispricings to be exploited. Therefore, an investor cannot hope to profit from interest rate differentials even in the short term.
The forward rate parity does not hold well in the short term. The forward rate parity theory assumes that forward rates (derived through CIP) accurately predict future spot rates (derived through UIP).
Since the UIP theory does not hold well in the short term, the forward exchange rates are not used to predict future expected spot rates, and the forward rate parity theory does not work in the short term.
Yes. The primary concern with carry trade is the working of the UIP theory. But, since this theory does not hold good in the short term, investors can use temporary interest rate differentials to make a profit.
Essentially, the depreciation of the higher-yielding currency will not offset the effects of interest rate differentials. In our example, INR may depreciate, but not enough to offset the yield differences.
Therefore, the investor can still exploit these differentials and make a profit.
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