Advanced Financial Management · Management of international trade and finance

Interest Rate Risk Management: FRAs, Futures, Options and Swaps

Updated 11 October 2026 · Fact-checked

Interest rate risk is the risk that a change in rates raises your borrowing cost or cuts your deposit income. You hedge it with forward rate agreements, interest rate futures, options, caps, collars or swaps. To solve a question, identify the exposure, choose the hedge, then calculate the effective rate achieved.

Understand Interest Rate Risk Management

Interest rate risk is the effect of rate changes on cash flows and value. A company with floating-rate debt loses when rates rise. A company with fixed-rate debt loses when rates fall, because it is stuck paying above-market rates. A company that will deposit surplus cash loses when rates fall.

First, decide which way you are exposed. A borrower fears rising rates. A depositor fears falling rates. Every hedge in this topic is built around that one question. Get the direction wrong and the whole answer is wrong.

The main tools are these:

Forward rate agreement (FRA): an OTC contract that fixes a rate for a future loan or deposit period. Only the interest difference is settled, in cash. The company still borrows or deposits separately in the market.
Interest rate future: an exchange-traded FRA-like contract. The price is 100 minus the rate. A borrower sells futures. A depositor buys them.
Interest rate option, cap, floor and collar: these protect you from bad moves but let you keep the good ones, in exchange for a premium. A cap sets a maximum rate. A floor sets a minimum rate. A collar combines the two to cut the premium.
Interest rate swap: two parties exchange interest payments, usually fixed for floating, on a notional principal. The principal itself is not exchanged.

FRAs, futures and options fix or limit the rate for a single period. Swaps suit long-term exposure. The exam also asks you to compare methods on cost, flexibility, basis risk, counterparty risk and whether you can benefit from favourable moves.

Key rules to remember

FRA quote notation: 3v9 FRA = starts in 3 months, ends in 9 months, covers a 6-month period; Take the bank's two-way quote. A borrower uses the higher rate. A depositor uses the lower rate.
FRA settlement (before discounting): Settlement = (Market rate − FRA rate) × Principal × months ÷ 12; If the market rate is above the FRA rate, the bank pays you. If it is below, you pay the bank. Interest is normally settled at the start of the period, so discount by 1 + (market rate × months ÷ 12).
Interest rate futures price: Futures price = 100 − implied interest rate (%); A borrower sells futures to hedge. A depositor buys futures. A rate rise lowers the price.
Tick value: Tick value = Contract size × 0.01% × contract months ÷ 12; For a 3-month contract of $1,000,000 the tick value is $25.
Number of futures contracts: Contracts = Principal ÷ Contract size × Hedge period ÷ Contract period; Use whole contracts. Match the contract expiry to the date the rate is fixed, not the end of the loan.
Futures hedge outcome: Method 1 (rate): Effective rate = (100 − opening futures price) ± basis adjustment. Method 2 (cash): Net interest cost = loan interest at actual rate − futures gain (or + futures loss); Gain or loss = ticks moved × tick value × contracts. Method 1 gives the lock-in rate: the implied rate at opening, adjusted for basis. Method 2 gives a cash cost, which you can convert back to a rate. Basis is the difference between the spot rate and the futures-implied rate. Basis risk means the hedge is rarely perfect.
Interest rate option (call and put on futures): Borrower buys a put on futures. Depositor buys a call on futures. Effective rate ≈ (100 − exercise price) adjusted for basis, plus the premium cost converted to a rate.; Exercise only if it beats the market. If you exercise, the futures position is closed out and the gain or loss on it, together with basis, moves your rate away from the strike. Before basis, the rate locked in is 100 − strike. If you do not exercise, you borrow at the market rate. Premium is paid upfront.
Cap, floor and collar: Cap = max rate. Floor = min rate. Collar = buy cap + sell floor (borrower).; Before premiums, the borrower's rate sits between the floor and cap strike rates. Premium received on the floor reduces the cap premium paid, so the net cost is the cap premium less the floor premium. An interest rate guarantee is a single-period OTC option, whereas a cap is a series of such options.
Swap net cost: Net cost = rate paid to lender + swap payment − swap receipt; Check both parties and the bank. The total gain from the swap equals the difference between the fixed-rate spread and the floating-rate spread, less any bank fee. With no bank, there is no fee to deduct.

How to solve Interest Rate Risk Management questions

Use the same sequence for any interest rate hedging question. Write each step clearly so you pick up method marks even if a number slips.

1Identify the exposure. Is the company borrowing or depositing? Is the rate fixed or floating? When does the exposure start and how long does it last?
2State the direction of risk. Borrower: rates rising is bad. Depositor: rates falling is bad.
3Choose the hedge required by the question, such as FRA, futures, options, collar or swap, and state the position: borrower sells futures, buys puts, buys a cap, or pays fixed in a swap.
4Calculate the hedge for the given rate scenario or scenarios. Work out the FRA settlement, the futures gain or loss, or the option exercise decision. Use the exact month fractions.
5Work out the net outcome, including the premium and the actual loan interest, and express it as an effective interest rate or a total cost.
6Compare the outcomes across methods or scenarios. Say which one costs least and what each leaves you exposed to.
7Comment on the risks that remain: basis risk, counterparty risk, margin requirements, premium cost and lost upside.
8Give a clear recommendation tied to the company's circumstances and finish with the figure.

Quickest way: Direction, then lock or limit

When to use it: Use this when you have limited time and need a first-pass answer or a check on a long calculation.

Write one line: borrower or depositor, and which way rates hurt.
For an FRA, compute (market rate − FRA rate) × principal × months ÷ 12 and check the sign against the direction of risk. The effective rate should equal the FRA rate.
For futures, sell for a borrower and buy for a depositor. Ticks moved × tick value × contracts gives the gain or loss. Compare it against the extra loan interest.
For options, compare the strike to the market. Exercise only if the strike is better than the market rate. Add the premium to the cost.
For swaps, check that every party's net rate equals what they would get without the swap, less their share of the gain. This confirms your arithmetic.

Common mistakes in Interest Rate Risk Management

Hedging in the wrong direction, for example buying futures when the company is a borrower.
Students memorise buy or sell without linking it to the price falling when rates rise.
Fix: Remember that futures price = 100 − rate. A borrower fears a rate rise, which means a price fall, so the borrower sells futures first.
Using the wrong time period in FRA or futures calculations, for example 9 months instead of 6 months for a 3v9 FRA.
The notation shows the end date, not the length of the period.
Fix: Subtract: 9 − 3 = 6 months. Write the period next to the principal before calculating.
Ignoring the premium, or not adjusting it for the time value when it is paid upfront and the interest is paid later.
Students focus on the exercise decision and forget the cost of the option.
Fix: Add the premium to the outcome for every scenario, including when the option lapses. Compound it to the interest payment date if the question asks for that.
Rounding the number of futures contracts or mixing up contract months with loan months.
The formula has two time ratios and it is easy to invert one.
Fix: Write principal ÷ contract size first, then multiply by loan months ÷ contract months. Round to the nearest whole contract and state that you have done so.
Treating a swap as an exchange of principal, or allocating the swap gain wrongly.
Students confuse swaps with currency swaps.
Fix: State that only interest is exchanged on a notional amount. Compute total gain as the difference in spreads, then split it as the question says. Check each party ends up with the saving.
Listing features of each hedge without recommending anything.
Students run out of time or think a list earns full marks.
Fix: Link each comment to the scenario, then conclude. For example, say a collar suits a firm that wants cheap protection and will accept a floor on its gains.

Worked examples

Example 1

Aster Ltd will need to borrow $10 million in 3 months' time for 6 months. It is worried about rising rates. A bank offers a 3v9 FRA at 4.20%. In 3 months, the benchmark rate for the 6-month loan turns out to be 5.10%. Calculate the FRA settlement and the effective interest cost. Then repeat if the rate instead falls to 3.50%.

Show the solution

Exposure: Aster is a borrower, so rising rates hurt. It buys the FRA to fix the rate at 4.20%. The FRA covers 9 − 3 = 6 months.
Rate rises to 5.10%: the market rate is above the FRA rate, so the bank pays Aster. Settlement before discounting = (5.10% − 4.20%) × $10,000,000 × 6 ÷ 12 = 0.9% × $10,000,000 × 0.5 = $45,000.
The settlement is paid at the start of the loan period. Discount it at the market rate: $45,000 ÷ (1 + 0.0510 × 6 ÷ 12) = $45,000 ÷ 1.0255 = about $43,881.
Check: the loan interest at 5.10% is $10,000,000 × 5.10% × 0.5 = $255,000, paid at the end of the period. Aster receives the discounted $43,881 at the start. Compounded at 5.10% for 6 months, it is worth $45,000 at the end. So $255,000 − $45,000 = $210,000. That is $10,000,000 × 4.20% × 0.5, so the effective rate is 4.20%.
Rate falls to 3.50%: the market rate is below the FRA rate, so Aster pays the bank. Settlement before discounting = (4.20% − 3.50%) × $10,000,000 × 0.5 = $35,000, which is about $34,398 after discounting at 1.0175.
Check: loan interest at 3.50% = $175,000, paid at the end. Aster pays the discounted $34,398 at the start. Financed at 3.50% for 6 months, it becomes $35,000 at the end. Total cost = $175,000 + $35,000 = $210,000, which is again 4.20%.

Answer: The FRA fixes Aster's cost at 4.20% (about $210,000 of interest for 6 months). If rates rise to 5.10%, the bank pays about $43,881 at the start of the loan period. If rates fall to 3.50%, Aster pays about $34,398. The FRA protects against rises but gives up the benefit of falls.

Example 2

Company A can borrow fixed at 4.0% or floating at benchmark + 0.3%. Company B can borrow fixed at 5.5% or floating at benchmark + 1.0%. A wants floating-rate debt and B wants fixed-rate debt. Design a swap, without a bank, that shares the gain equally. State each company's net borrowing cost.

Show the solution

Compare the spreads. Fixed-rate difference = 5.5% − 4.0% = 1.5%. Floating-rate difference = 1.0% − 0.3% = 0.7%.
Total gain from swapping = 1.5% − 0.7% = 0.8%. Equal split = 0.4% each.
A has the advantage in fixed borrowing, so A borrows fixed at 4.0% from its lender. B borrows floating at benchmark + 1.0% from its lender, which is where B has the smaller disadvantage.
Target costs: A wants floating at (benchmark + 0.3%) − 0.4% = benchmark − 0.1%. B wants fixed at 5.5% − 0.4% = 5.1%.
Set the swap: B pays A a fixed rate x, and A pays B the floating benchmark. A's net = 4.0% + benchmark − x = benchmark − 0.1%, so x = 4.1%.
Check B: pays benchmark + 1.0% to its lender, pays 4.1% fixed to A, receives benchmark from A. Net = 1.0% + 4.1% = 5.1%. This is 0.4% better than 5.5%.
Check A: net = benchmark − 0.1%, which is 0.4% better than benchmark + 0.3%. Total saving = 0.4% + 0.4% = 0.8%, as calculated.

Answer: A borrows fixed at 4.0% and B borrows floating at benchmark + 1.0%. Under the swap, B pays A 4.1% fixed and A pays B the benchmark rate. A's net cost is benchmark − 0.1%. B's net cost is 5.1% fixed. Each saves 0.4%.

Exam tips

Write the direction of exposure at the top of every answer. It earns marks and stops you hedging the wrong way.
Show the effective rate for every scenario. Examiners often give two or three rate outcomes and reward a clear comparison table in words or lines.
Always include the premium for options and the margin and basis comments for futures. These are easy discussion marks.
The professional skills marks reward a clear recommendation for the client. After the numbers, say which hedge you would choose and why, given the client's view on rates and its appetite for risk.
Keep your discussion tied to the case. Mention things like the loan term, whether the exposure is certain, and whether exchange-traded contracts match the dates and amounts.

Practice questions from Management of international trade and finance

Interest Rate Risk Management 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 Management: frequently asked questions

How do I calculate a forward rate agreement settlement in AFM?

Take the market rate minus the FRA rate, multiply by the principal and by months ÷ 12. If the market rate is higher, the bank pays you. Discount the settlement by 1 + (market rate × months ÷ 12) when the question says it is paid at the start of the period.

What is the difference between an interest rate cap and a collar?

A cap sets a maximum rate for the borrower and the borrower pays a premium for it. A collar combines a cap with a floor that the borrower sells. The floor premium reduces the cost, but the borrower gives up the benefit if rates fall below the floor.

Does a borrower buy or sell interest rate futures?

A borrower sells futures. If rates rise, the futures price falls and the borrower makes a gain that offsets the higher interest cost. A depositor buys futures for the opposite reason.

How do I hedge interest rate risk with options?

A borrower buys a put option on futures, an interest rate guarantee or a cap. An interest rate guarantee is a single-period OTC option, whereas a cap is a series of such options. You exercise only if the option rate beats the market rate. The premium is paid either way, so include it in the effective cost.