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

A company compares hedging a future floating-rate borrowing using an FRA, an interest rate guarantee (OTC option) and a cap. Which statement about the comparison is correct?

An interest rate guarantee is an option, so it costs an upfront premium but protects against rate rises while letting the borrower take advantage of falling rates by not exercising it. FRAs are binding and have no premium.

  1. AAn FRA requires an upfront premium but lets the company benefit from falling rates
  2. BAn interest rate guarantee requires no premium and fixes the rate
  3. CAn interest rate guarantee requires an upfront premium and allows the company to benefit from falling ratesCorrect
  4. DA cap fixes the rate exactly and has no cost

Explanation

Options such as guarantees carry a premium and protect against adverse movement while allowing the holder to abandon the option if rates fall. FRAs have no premium but are binding. A cap sets a maximum rate and costs a premium.

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