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What is Interest Rate Differential and How to Calculate it?

Interest Rate Differential is a penalty for early prepayment of all or part of a mortgage outside of its normal prepayment terms. This is considered a key component of the carry trade. This Interest rate is a type of compensation, which is charged by the lender if the borrower pays off his mortgage principal prior to the maturity date. Interest Rate Differential is also known as: Loss of interest, IRD and Differential interest rate.

Here are some features of Interest Rate Differential:

  • 1. Interest Rate Swap - It is an interest rate swap which is in a 'penalty form'.
  • 2. Calculation Method - It is usually calculated as the difference between the existing rate and the rate of the term remaining, multiplied by the outstanding principal and the balance of the term.
  • 3. Precise Calculation - It is a very precise calculation criterion.
  • 4. Mentions The Compensation Due - It usually refers to the compensation due to the lender on payout of mortgage.
  • 5. Early Prepayment Penalty - It is a prepayment penalty to the borrower for early prepayment of mortgage debt, before the maturity of mortgage term.

This is usually calculated as "the difference between the existing rate and the rate for the term remaining, multiplied by the principal outstanding and the balance of the term". This is how interest rate is computed:

Example: $100,000 mortgage at 9% with 24 months remaining / Current 2-year rate is 6.5% / Differential is 2.5% per annum / IRD is $100,000 * 2 years * 2.5% p.a. = $5,000

A differential measures the gap in interest rates among two similar interest-bearing assets. Based on the interest rate uniformity, 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. Traders in the foreign exchange market use interest rate differentials when pricing forward exchange rates.

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 interest rate differential equals 4% (7%-3%). This type of interest rate 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. The spread between domestic and foreign interest rates is an important erratic that central banks consider in their policies at the macroeconomic level. It is also a changeable of interest for investors in the foreign exchange market who are engaged in currency carry trade. A systematic understanding of the time series properties of this type of interest rate and their persistence across countries is, hence, of importance for both policymakers as well as investors. Interest rates are an important variable of interest to those engaged in carry trade, "a strategy where an investor borrows in a foreign country with lower interest rates than their home country and invests the funds in their domestic market, usually in fixed-income securities.

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