What Is an Interest Rate Differential?
What is an interest rate differential? It is the gap between the interest rates behind the two currencies of a pair, usually measured with the two central banks’ policy rates. Money tends to move toward the higher yield, so the gap gives the higher-rate currency a steady source of demand.
How to calculate it
Subtract the quote currency’s rate from the base currency’s. An example with invented numbers:
- The base currency’s central bank sets 4.50%; the quote currency’s sets 0.50%.
- The differential is 4.50 − 0.50 = +4.00 percentage points, in favour of the base.
- A negative result means the quote currency pays more.
Today’s policy rate and two-year yield differentials for every major pair, base minus quote, are on Interest rate differential by currency pair, and beside each pair’s last price on Major forex pairs: prices and fundamentals.
How it reaches your account as swap
On a leveraged position, the broker settles the differential every day as swap, also called rollover, minus its markup. Holding the higher-yielding side usually earns it; holding the lower-yielding side pays it.
Holding a position mainly to collect that gap is a carry trade: Carry Trade Guide: How It Works and Why It Unwinds.
Why the expected gap matters more
The gap you can look up today is mostly in the price already. A pair moves when the expected gap changes: when an inflation report, a jobs report or a central bank’s guidance changes where markets think the two banks’ rates will end up. Where each path is expected to peak is its terminal rate.
Inflation changes the picture too. A high rate is worth less where prices rise fast, so longer-term money weighs the gap after inflation, on Real interest rates by currency.
When it stops working
In a sudden flight from risk, money can move into safe-haven currencies whatever they pay, and the differential matters less for a while. How the expected and real gaps fit together, and where the differential gives way, is in Anatomy of a Rate Differential.