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

A company has a floating-rate loan and fears rates will rise, but wants to benefit if rates fall. Which hedge best meets this aim?

Buying an interest rate cap fits best. It sets a ceiling on the borrowing rate if rates rise, yet the company still benefits from lower rates, paying only the premium. Swaps and FRAs fix the rate, removing the downside benefit.

  1. ABuy an interest rate capCorrect
  2. BEnter a pay-fixed interest rate swap
  3. CBuy a forward rate agreement
  4. DSell an interest rate floor

Explanation

A cap sets a maximum rate while allowing the borrower to gain from lower rates, at the cost of an upfront premium. A pay-fixed swap and an FRA both lock in a rate and remove the benefit of falls. Selling a floor gives no protection against rate rises.

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