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 Traders in the foreign exchange market use interest rate differentials (IRD) when pricing forward exchange rates. Based on the interest rate parity, 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.
The IRD is a key component of the carry trade. 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 IRD equals 4% (7-3%). The IRD 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.
Thursday, 10th September 2009
Sources:
Http://www.investopedia.com |
