Interest Rate Differential

An interest rate differential is the difference in interest rates between two debt instruments, say, different maturity points of a government bond yield curve, or between same-maturity government bonds in different countries (and therefore in different currencies). A bond with a yield of 4% has a 150bp (or 1.5 percentage point) differential to a bond yielding 2.5%. Interest-rate differentials drive the huge market in leveraged FX carry trades, where investors borrow money in a low-yielding currency and invest it in a high-yielding currency – JPY/AUD has been a popular carry trade. The investor earns the differential (less fees) assuming the exchange rate remains constant.