What is Interest Rate Differential in Forex Trading?

The interest rate differential measures the difference in interest rate of two different currencies. The traders of foreign exchange market use interest rate differential when valuing the forward exchange rates. IRD is often used in lending markets, forex and fixed income. It also play an important role in calculating the carry trade. A carry trade is strategy that foreign exchange traders used to generate profit from difference in interest rates. For example, if the interest rate of Australian dollar is 4% and interest rate of Japanese yen is 2.5%, then the interest rate differential between the two currencies is 1.5%.