Interest Rate Differential
An Interest Rate Differential is the measure of how much one end of a currency pair pays in interest minus how much the other end of the currency pair charges in interest.
In Forex trading is done by selling one currency short and using the proceeds to purchase another long. The two currencies in the transaction are referred to as a Currency Pair. Interest is earned with a trade when the shorted currency charges less interest than it is invested in with the long currency. A good example is a long NZD/JPY Forex trade. If the trader shorted JPY at 0.1% per year and when long NZD at 3.5% per year the trade would earn 3.5% – 0.1% = 3.4% per year. This 3.4% is the Interest Rate Differential of the long NZD/JPY Forex trade. Keep in mind that many Forex traders use high amounts of leverage which has the effect of greatly amplifying the net Interest Rate Differential for these types of Forex trades.