Definition of Net Interest Rate Differential
In the international markets, it is the difference in the interest rates appealing of two distinct economic regions.
Brief Explanation of Net Interest Rate Differential
If a dealer is extended the NZD/USD pair, he or she owns the New Zealand exchange and borrows the US exchange. These New Zealand dollars can be sited into a New Zealand bank while concurrently taking out a loan for the equal amount from the U.S. bank. The net interest amount differential is the step up in any interest earned and any interest paid at the same time as holding the exchange pair position.
The net interest amount differential reveals the improvement in rates appealing offered by two countries. This differential is typically used to price exchange forward contracts through the eye amount parity equation. A discrepancy between fundamental parity conditions and actual rates appealing offered presents an exchange arbitrage opportunity.
The net interest amount differential is a fundamental component of the eye amount parity theory, whereby the improvement in rates appealing between two countries equals the distinction between the current and predictable exchange rates among the two currencies. As a result, the net interest amount differential is a key factor in pricing exchange forward contracts.