Advanced Financial Management · The use of financial derivatives to hedge against interest rate risk

Interest Rate Risk and Yield Curves for ACCA AFM

Updated 11 October 2026 · Fact-checked

Interest rate risk is the chance that changes in interest rates reduce profit or value. Borrowers lose when rates rise on floating debt; investors lose when rates fall. The yield curve shows yield against maturity. Term structure theories explain its shape and help you choose between fixed and floating finance and hedges.

Understand Interest Rate Risk and Yield Curves

Interest rate risk is the risk that a movement in interest rates hurts your cash flows or the value of your assets and liabilities. It arises from the way a company is financed and where it places surplus cash.

A borrower with floating-rate debt loses when rates rise, because interest costs go up. A borrower with fixed-rate debt is protected on cash flow, but loses out if rates fall, because it is stuck paying above-market rates. An investor or a company with surplus cash is the mirror image. Floating deposits lose when rates fall. Fixed-rate investments lose market value when rates rise.

Several types of risk matter in the exam. Gap risk (or repricing risk) arises when assets and liabilities reprice at different dates, so interest income and expense do not move together. Basis risk arises when the rates on two items are linked to different benchmarks or move by different amounts, or when a hedge does not move perfectly with the underlying exposure. Yield curve risk arises when the curve shifts or changes shape, not just moves in parallel. Reinvestment and refinancing risk arise when you must roll over debt or deposits at an unknown future rate.

The yield curve plots the yield on similar-risk bonds (usually government bonds) against time to maturity. It can be upward sloping (normal), downward sloping (inverted) or flat. Three theories explain the shape. Expectations theory: long rates are an average of expected future short rates, so an upward curve means the market expects rates to rise. Liquidity preference theory: investors demand a premium for lending long because long bonds are more price-sensitive and less liquid, so the curve tends to slope upward even if rates are expected to stay level. Market segmentation theory: different groups of borrowers and lenders prefer different maturities, so each maturity has its own supply and demand.

For hedging, the question is always the same. Where is the exposure, which way does it hurt, how big is it, and for how long? The curve then helps you judge whether the market expects rates to rise or fall. It also shows the cost of fixing now. It does not let you forecast rates reliably, so you must use it with care.

Key rules to remember

Interest cost change from a rate move: Change in interest = Exposed amount × Change in rate × Time in years; Use only the floating-rate, unhedged amount. For part-years use months ÷ 12.
Net floating exposure: Net exposure = Floating-rate liabilities − Floating-rate assets; A positive figure means you lose when rates rise. A negative figure means you lose when rates fall.
Expectations theory (annual compounding): (1 + s₂)² = (1 + s₁) × (1 + f₁,₂); s₁ and s₂ are spot rates for 1 and 2 years. f₁,₂ is the implied forward rate for year 2.
Implied forward rate: f₁,₂ = (1 + s₂)² ÷ (1 + s₁) − 1; Works for annual rates. Rearranged form of the expectations formula.

How to solve Interest Rate Risk and Yield Curves questions

Use this method for any question on interest rate exposure or the yield curve.

1List every borrowing and deposit. Note whether each is fixed or floating, the amount, the benchmark and the repricing date.
2Net the floating assets against the floating liabilities to find the true exposure. Decide whether rising or falling rates hurt.
3Identify the type of risk: gap, basis, yield curve, or refinancing. Use the scenario wording to decide.
4Quantify the effect. Multiply the exposed amount by the rate change and the time period.
5Read the yield curve. State its shape and what each theory says about future rates.
6Link to a decision: fix, stay floating, match, or hedge. Name suitable instruments, such as FRAs, futures, options or swaps.
7Comment on limits. Forecasts are uncertain, hedges cost money and basis risk may remain.
8Apply the answer to the company. Use its figures and its attitude to risk.

Quickest way: Direction and size in four lines

When to use it: Use this when time is short and the question asks you to identify or quantify exposure.

Write floating debt minus floating deposits. This is your net exposure.
Rates up hurts if the net figure is positive. Rates down hurts if it is negative.
Multiply the net figure by the rate change and by months ÷ 12.
Add one line on the curve: upward slope means the market expects rises, or a liquidity premium, or both.

Common mistakes in Interest Rate Risk and Yield Curves

Treating all debt as exposed to rate rises.
Students forget to check whether the loan is fixed or floating.
Fix: Tag each item fixed or floating first. Fixed debt has no cash flow exposure to rate moves, though it carries an opportunity cost.
Confusing basis risk with gap risk.
Both involve mismatches, so the names blur.
Fix: Gap risk is about timing: items reprice on different dates. Basis risk is about the rate: items follow different benchmarks or a hedge does not track the exposure.
Saying an upward yield curve proves rates will rise.
Students learn only expectations theory.
Fix: State that under liquidity preference the slope can also reflect a term premium. Mention both explanations.
Ignoring deposits when finding exposure.
Students look only at the loan.
Fix: Net floating assets against floating liabilities. Cash on floating deposit offsets part of the borrowing exposure.
Using the full year for a part-year exposure.
Rushing the calculation.
Fix: Multiply by months ÷ 12 for the period the exposure is actually open.
Giving theory without applying it to the scenario.
Students recite definitions to fill space.
Fix: Use the company's debt levels, dates and attitude to risk in every paragraph. This earns professional skills marks.

Worked examples

Example 1

Nexa Ltd has $40 million floating-rate loans, $10 million fixed-rate loans and $6 million floating-rate deposits. Rates are expected to rise by 1.5% over the next six months and then stay there. Calculate the net floating exposure and the extra interest cost over the six months, and state which direction of rate movement hurts Nexa.

Show the solution

Floating liabilities are $40 million. Floating assets are $6 million.
Net floating exposure = 40 − 6 = $34 million of net floating liability.
The fixed loan of $10 million is not exposed on cash flow, so it is ignored.
Extra interest = 34,000,000 × 1.5% × 6/12.
34,000,000 × 0.015 = 510,000. Half a year gives 255,000.
The net exposure is a liability, so rising rates hurt.

Answer: Net floating exposure is $34 million. The extra interest cost over six months is $255,000. Rising rates hurt Nexa.

Example 2

The one-year spot rate is 4% and the two-year spot rate is 5%, both annual. Calculate the one-year forward rate starting in one year implied by expectations theory, and explain what the upward slope may mean.

Show the solution

Use (1 + s₂)² = (1 + s₁) × (1 + f).
(1.05)² = 1.1025.
Divide by 1.04: 1.1025 ÷ 1.04 = 1.06010.
Subtract 1: f = 0.0601, or 6.01%.
Under expectations theory, the market expects one-year rates to be about 6.01% in a year, so rates are expected to rise.
Under liquidity preference, part of the slope may be a premium for lending long, so the expected rise may be smaller.

Answer: The implied forward rate is about 6.01%. The upward slope suggests expected rate rises under expectations theory, but liquidity preference says part of it may be a term premium.

Exam tips

Start every answer by finding the net floating exposure. Examiners reward this first step.
Name the risk type precisely. Use gap, basis, yield curve or refinancing risk, rather than saying only interest rate risk.
When discussing the curve, give at least two theories. Say which fits the scenario and why.
Link the exposure to a hedging recommendation and its limits. Do not stop at identification.
Show your workings with months ÷ 12 clearly. Marks follow method even if arithmetic slips.

Practice questions from The use of financial derivatives to hedge against interest rate risk

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 basis risk and gap risk?

Gap risk comes from items repricing on different dates, so interest income and cost move at different times. Basis risk comes from items tied to different benchmarks, or from a hedge that does not track the underlying rate exactly. Both can leave a company partly exposed even after hedging.

What are the main yield curve theories?

Expectations theory says long-term rates reflect expected future short-term rates. Liquidity preference theory adds a premium for lending long. Market segmentation theory says supply and demand at each maturity set rates separately.

How do I identify interest rate exposure in an AFM question?

List all debt and deposits, mark each fixed or floating, and net the floating ones. Then decide whether rising or falling rates hurt. Check repricing dates and benchmarks for gap and basis risk.

Can the yield curve predict future interest rates?

Not reliably. The curve can imply forward rates, but these may include a risk premium and the market can be wrong. Treat it as one input, not a forecast.