An interest rate differential is a difference in interest rate between two currencies in a pair. If one currency has an interest rate of 2 percent and the other has an interest rate of 0.5 percent, it has a 1.5 percent interest rate differential. The use of interest rate differentials is of particular concern in foreign exchange markets for pricing purposes.

If you were to buy the currency that pays 2 percent against the currency that pays 0.5 percent, you would be paid on the difference with daily interest payments. This simple definition is known as the carry trade, earning carry on the interest rate differential.