Financial Management · The nature and types of risk and approaches to risk management

Interest Rate Risk and Yield Curves for ACCA FM

Updated 11 October 2026 · Fact-checked

Interest rate risk is the chance that changes in interest rates hurt a firm's profit or value. Floating debt exposes cash flows. Fixed debt exposes you to opportunity cost. Basis risk arises when hedge and exposure rates move differently. A yield curve plots yield against maturity, and theories explain its shape.

Understand Interest Rate Risk and Yield Curves

Interest rate risk is the risk that a change in interest rates reduces profit, cash flow or value. It affects borrowers and investors. A company that borrows is hurt when rates rise. A company that deposits cash is hurt when rates fall.

The size of the exposure depends on gearing and on the mix of debt. The more debt a firm has, the more interest it pays, and the more a rate move changes profit. High gearing with floating-rate debt means a rate rise cuts profit and interest cover quickly. This can also threaten covenants.

Fixed versus floating. Floating-rate debt moves with a benchmark rate, so interest cost is uncertain. If rates rise, you pay more. If rates fall, you pay less. Fixed-rate debt gives certainty of cost, but you lose if rates fall, because you are locked in at a higher rate. Fixed debt may also carry early repayment penalties. A common policy is to match: use floating debt against assets whose income moves with rates, and fixed debt when you need stable cash flow.

Basis risk is the risk that the rate on your hedge and the rate on your exposure do not move together. For example, you borrow at a bank's base rate plus a margin but hedge with a futures contract tied to a different benchmark. The hedge may then gain or lose by a different amount than the loan. Basis risk can also arise in futures when the futures price and the spot rate do not converge as expected.

A yield curve plots yields on similar-risk bonds, usually government bonds, against time to maturity. A normal curve slopes upward. It can also be flat or inverted (downward). The term structure of interest rates is the relationship between yield and maturity. Three main theories explain its shape.

Expectations theory: long-term rates are an average of expected future short-term rates. A rising curve means the market expects rates to rise. A falling curve means it expects them to fall.
Liquidity preference theory: investors prefer liquidity and demand a premium for tying up money for longer. So long-term yields are higher than expectations alone would give. The curve tends to slope upward, even if rates are expected to stay flat.
Market segmentation theory: the market is split into short, medium and long-term segments. Each has its own supply and demand, which set yields independently.

The curve helps a financial manager decide whether to borrow short or long, and it indicates what the market expects.

Key rules to remember

Interest cost change from a rate move: Change in annual interest = Floating debt × change in rate; Apply only to the floating part of debt. Fixed debt does not change until it is refinanced.
Interest cover: Interest cover = Profit before interest and tax ÷ Interest; Use it to show how a rate rise squeezes a highly geared firm.
Expectations theory (annual compounding): (1 + long rate)^n = (1 + s1) × (1 + f2) × ... × (1 + fn); s1 is today's one-year rate and f2 to fn are expected future one-year rates.
Liquidity preference theory: Long-term yield = Expected average short rate + liquidity premium; The premium usually rises with maturity. It is a rule of the theory, not a number to calculate unless given.

How to solve Interest Rate Risk and Yield Curves questions

Use this approach for written and numerical questions on interest rate exposure and the yield curve.

1Identify who is exposed: a borrower, an investor or both. State which direction of rate move hurts.
2Split the debt into fixed and floating. Only the floating part gives immediate cash flow risk.
3Quantify the effect. Multiply floating debt by the rate change, then adjust for tax only if the question asks.
4Link the result to gearing and interest cover, and say why a highly geared firm is more exposed.
5Check for basis risk. Ask whether the hedge is based on the same rate as the exposure.
6For yield curve questions, read the shape first, then explain it using the theory the question names.
7Give a clear recommendation or conclusion, such as fix, stay floating or hedge, with a reason tied to the scenario.

Quickest way: Four-line exposure check

When to use it: Use in Section A or in an OT case when you must pick the right statement fast.

Floating debt plus rising rates means higher cost. Fixed debt plus falling rates means opportunity cost.
Compute floating debt × rate change if a figure is needed.
If the hedge uses a different rate from the loan, the answer involves basis risk.
Upward curve: expectations means rising rates expected. Liquidity preference means a premium for longer maturities. Segmentation means separate markets.

Common mistakes in Interest Rate Risk and Yield Curves

Saying fixed-rate debt removes all interest rate risk.
Students think certainty of cost means no risk.
Fix: Say it removes cash flow risk but leaves opportunity cost if rates fall, and the rate is exposed at refinancing.
Applying a rate change to total debt when part is fixed.
Students skip the split between fixed and floating.
Fix: Underline the floating balance first and use only that figure.
Confusing basis risk with the risk that rates move at all.
Both involve rate movements.
Fix: Basis risk is about the hedge and exposure rates failing to move together, not about rates moving.
Explaining liquidity preference as the belief that rates will rise.
It is mixed up with expectations theory.
Fix: Liquidity preference adds a premium for tying up funds. Expectations theory is about expected future short rates.
Saying an upward-sloping curve always means rates will rise.
Students apply expectations theory only.
Fix: Under liquidity preference, an upward slope can come from the premium alone. State which theory you use.
Giving a recommendation with no link to the scenario.
Students write general theory in constructed responses.
Fix: Tie advice to gearing, cash flow stability and the company's rate view.

Worked examples

Example 1

Delta Co has ₹40,00,000 of debt: ₹25,00,000 floating and ₹15,00,000 fixed at 6%. Floating debt costs 5%. Rates rise by 2 percentage points. Calculate the change in annual interest and the new total interest.

Show the solution

Only the floating debt is affected: ₹25,00,000.
Change in interest = ₹25,00,000 × 2% = ₹50,000.
Current floating interest = ₹25,00,000 × 5% = ₹1,25,000.
Fixed interest = ₹15,00,000 × 6% = ₹90,000.
Current total = ₹1,25,000 + ₹90,000 = ₹2,15,000.
New total = ₹2,15,000 + ₹50,000 = ₹2,65,000.

Answer: Annual interest rises by ₹50,000 to ₹2,65,000. The fixed debt is unaffected.

Example 2

The one-year spot rate is 4%. The market expects the one-year rate in a year's time to be 6%. Using expectations theory with annual compounding, find the two-year spot rate. Then say what liquidity preference theory would add.

Show the solution

Two-year equation: (1 + s2)^2 = 1.04 × 1.06.
1.04 × 1.06 = 1.1024.
s2 = √1.1024 − 1.
√1.1024 = 1.04995, to five decimal places.
So s2 is about 4.995%, or roughly 5.0%.
Liquidity preference theory would add a premium for the longer maturity, so the actual two-year yield would be above this figure.

Answer: The two-year spot rate is about 5.0% under expectations theory. Liquidity preference theory suggests the observed yield would be higher because of the premium.

Exam tips

In OT questions, read the exact wording. Terms like 'basis risk', 'opportunity cost' and 'cash flow risk' point to different answers.
Do the fixed and floating split before any calculation. Many marks are lost by using total debt.
For written parts, name the theory, state its logic in one sentence, then link to the curve shape given.
For advice questions, give a clear view and a reason, such as high gearing and tight interest cover favouring fixed rates.
Remember that OT questions are all or nothing, so check the direction of effect before you select an answer.

Practice questions from The nature and types of risk and approaches to risk management

Interest Rate Risk and Yield Curves 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 Yield Curves: frequently asked questions

What is the difference between fixed and floating rate debt in ACCA FM?

Fixed-rate debt has an interest rate set for the term, so cash flows are certain but you lose if rates fall. Floating-rate debt moves with a benchmark rate, so cost is uncertain. Choose based on gearing, cash flow stability and your view of rates.

What is basis risk in interest rates?

Basis risk is the risk that the rate on a hedging instrument and the rate on the underlying exposure do not move together. The hedge then does not offset the exposure fully. It can happen when the loan and the hedge reference different benchmarks.

How do I explain liquidity preference theory?

Investors prefer to hold liquid assets and want extra yield for lending long-term. So long-term yields include a liquidity premium over expected short-term rates. This tends to give an upward-sloping curve even if rates are not expected to change.

What does an inverted yield curve mean?

It means short-term yields are above long-term yields. Under expectations theory, the market expects short-term rates to fall. The theory you quote should match the question.