What is the Net Interest Rate Differential?
Net interest rate differential is the difference in interest rates associated with two different currencies or two different economic regions.
How Does the Net Interest Rate Differential Work?
For example, let's assume an investor in Japan puts her Japanese savings in a Japanese bank and earns interest at Japanese interest rates (say 8%). Let's further assume that this investor then borrows money from an American bank and the loan is denominated in U.S. dollars. Because loans happen to be cheap in the U.S. at the time, the investor pays 6% on the loan. Now the investor can take advantage of the net interest rate differential by borrowing at 6% and putting in a Japanese bank to earn 8%, for a tidy 2% profit.
Why Does the Net Interest Rate Differential Matter?
The net interest rate differential is a fundamental component of the interest rate parity theory, whereby the difference in interest rates between two countries equals the difference between the current and expected exchange rates between the two currencies. As a result, the net interest rate differential is a key factor in pricing currency forward contracts.
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