Financial Management · Hedging techniques for interest rate risk

Interest Rate Risk and Its Causes in ACCA FM

Updated 11 October 2026 · Fact-checked

Interest rate risk is the risk that changes in interest rates reduce a firm's profit or value. Borrowers lose when floating rates rise or fixed rates are locked above market. Lenders lose when rates fall. To answer questions, identify the exposure, the direction of rate movement, and the cash effect.

Understand Interest Rate Risk and Its Causes

Interest rate risk is the chance that a change in interest rates makes a company worse off. It affects both what the company pays on borrowing and what it earns on deposits and investments. It also affects the market value of fixed-rate debt and investments.

Start with the fixed versus floating choice. With floating rate debt, the interest rate is reset regularly, usually as a benchmark rate plus a margin. If the benchmark rises, your interest cost rises. You gain if it falls. With fixed rate debt, your cost is certain, but you lose out if market rates fall, because you are stuck paying more than the market. So both types carry risk. Floating carries cash flow risk. Fixed carries opportunity cost.

Borrowers and lenders face opposite exposures. A borrower with floating debt fears rising rates. A company with floating-rate deposits fears falling rates. A company with both may be partly naturally hedged. Matching floating assets with floating liabilities is a simple internal way to reduce risk.

Gap exposure arises when the amounts of assets and liabilities that reprice in a given period do not match. For example, a firm has ₹10,00,000 of floating-rate borrowing but only ₹4,00,000 of floating-rate deposits. The unmatched ₹6,00,000 is exposed. Basis risk is different. It arises when the rates on your assets and liabilities are both floating but are linked to different benchmarks, or are reset on different dates. They may not move together, even if the amounts match. Basis risk also appears when a hedging instrument is based on a different rate from the exposure.

Yield curves show the yield on debt of the same credit quality at different maturities. Three theories explain their shape. Expectations theory: long rates reflect expected future short rates, so a rising curve signals expected rate rises. Liquidity preference theory: investors want a premium for lending long, so long rates are higher than expectations alone imply. Market segmentation theory: separate supply and demand in short and long markets set each rate, so the curve can take any shape. The general level of interest rates is driven by inflation, central bank policy and government borrowing. Credit risk is different. It affects the margin or spread charged to a particular borrower, not the general level of interest rates.

Key rules to remember

Change in annual interest cost: Change in interest = Exposed amount × Change in rate × (Months ÷ 12); Use only the unhedged amount that reprices, and the time period it is exposed for.
Gap exposure: Gap = Floating-rate liabilities − Floating-rate assets (same repricing period); Here the gap is defined as liabilities minus assets. Net floating liabilities (positive gap) lose if rates rise. Net floating assets (negative gap) lose if rates fall. Gap analysis in banking often uses the opposite sign (assets minus liabilities), so check the definition given in a question.
Fixed rate opportunity cost: Opportunity cost = Debt × (Fixed rate − Current market rate); Applies if market rates fall after you fix. Treat it as a cost relative to the market, not a cash cost increase.
Expectations theory (simple form): Long rate ≈ average of expected future short rates; Liquidity preference adds a premium on top of this for longer maturities.

How to solve Interest Rate Risk and Its Causes questions

Use this method for any question on interest rate risk causes and exposure.

1Identify each item as an asset or a liability, and as fixed or floating.
2Decide who is exposed: a borrower fears rising rates on floating debt, a depositor fears falling rates on floating deposits.
3Net off floating assets against floating liabilities that reprice in the same period to find the gap.
4Check whether the floating items use the same benchmark and reset dates. If not, note basis risk.
5Apply the rate change to the exposed amount and time period to get the cash effect.
6State the direction clearly: gain or loss, and increase or decrease.
7For yield curve questions, name the theory that matches the explanation asked for and give its reason.

Quickest way: Gap, direction, size

When to use it: Use this for objective test questions where you must pick the exposed amount or the effect of a rate move.

Cross out fixed items. They do not reprice in the period.
Subtract floating assets from floating liabilities to find the net gap.
Pick the direction: net floating debt loses if rates rise.
Multiply the gap by the rate change and the fraction of the year.
Check that your sign matches the direction before choosing an answer.

Common mistakes in Interest Rate Risk and Its Causes

Saying fixed rate debt has no interest rate risk.
Students focus only on cash flow certainty.
Fix: State that fixed debt removes cash flow risk but creates opportunity cost if market rates fall, and its market value changes.
Treating gap exposure and basis risk as the same thing.
Both involve mismatches.
Fix: Gap is a mismatch of amounts or repricing dates. Basis risk is a mismatch of benchmarks even when amounts match.
Applying the rate change to the full borrowing instead of the net exposed amount.
Students forget to net off floating deposits.
Fix: Always compute floating liabilities minus floating assets first.
Forgetting to time-apportion the interest effect.
The rate change is quoted per year, and the exposure lasts only part of a year.
Fix: Multiply by months ÷ 12 whenever the exposure period is under a year.
Mixing up the yield curve theories.
The names sound similar and the explanations overlap.
Fix: Link each to one idea: expectations means future short rates, liquidity preference means a premium for lending long, segmentation means separate markets.
Getting the direction wrong for a lender.
Students think rising rates always hurt.
Fix: Ask who pays and who receives. Rising rates help floating-rate lenders and hurt floating-rate borrowers.

Worked examples

Example 1

A company has ₹8,00,000 of floating-rate borrowing and ₹3,00,000 of floating-rate deposits, both repricing together. It also has ₹5,00,000 of fixed-rate debt. Interest rates rise by 2 percentage points for a full year. What is the effect on annual profit before tax?

Show the solution

Ignore the fixed-rate debt, as it does not reprice.
Net floating exposure = ₹8,00,000 − ₹3,00,000 = ₹5,00,000 net floating liability.
Change in interest = ₹5,00,000 × 2% = ₹10,000.
Rates rose, and the company is a net floating borrower, so it loses.

Answer: Profit before tax falls by ₹10,000.

Example 2

A company has floating-rate loans of ₹12,00,000 linked to a bank base rate. It holds ₹12,00,000 of floating-rate deposits linked to a money market rate. Both reset at the same time. Explain whether the company is exposed to interest rate risk.

Show the solution

Amounts match, so the gap is ₹12,00,000 − ₹12,00,000 = nil.
There is no gap exposure.
The loan and deposit use different benchmarks, so they may not move by the same amount.
If the base rate rises by 1% and the money market rate rises by only 0.6%, interest cost increases by more than interest income.
Net effect on that move = ₹12,00,000 × (1% − 0.6%) = ₹4,800 extra cost for a year.

Answer: There is no gap exposure, but there is basis risk. In the example, the company loses ₹4,800 over a year.

Exam tips

In objective tests, write the gap first. Many wrong options use the gross borrowing instead of the net amount.
Read the question for the time period. A six-month exposure is half the annual effect.
In written answers, state both the direction and the reason, for example: floating borrower, rates rise, cost rises.
When asked to explain yield curve shape, name the theory and tie it to the shape described. Do not just list all three.
Link causes to the situation: inflation expectations and central bank policy are the usual drivers in scenarios.

Practice questions from Hedging techniques for interest rate risk

Interest Rate Risk and Its Causes in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Interest Rate Risk and Its Causes: frequently asked questions

What is the difference between gap exposure and basis risk?

Gap exposure comes from a mismatch in the amounts or repricing dates of assets and liabilities. Basis risk comes from floating items being linked to different benchmark rates, so they may not move together even when the amounts match.

Is fixed rate debt safer than floating rate debt?

Fixed rate debt gives certain interest payments, so it removes cash flow uncertainty. However, if market rates fall, you still pay the higher fixed rate. Neither type is risk free.

Which yield curve theories does ACCA FM expect?

You should know expectations theory, liquidity preference theory and market segmentation theory. Be ready to explain what each says about why the curve slopes up, down or is humped.

Who gains when interest rates rise?

Holders of floating-rate deposits or investments gain because they earn more. Borrowers with floating-rate debt lose. Borrowers with fixed-rate debt see no change in cash cost, so they gain only an opportunity benefit relative to the market, not a profit gain. Lenders on fixed-rate investments lose relative to the market, because they are locked into a lower return.