ACCA Strategic Professional · Advanced Financial Management · The use of financial derivatives to hedge against interest rate risk
A company has floating-rate debt and expects rates to rise, but it also wants to retain the chance to benefit if rates fall, and accepts paying an upfront fee. Which hedge best suits these objectives?
Buying an interest rate cap is best because it caps the borrowing rate against rises for an upfront premium while leaving the company free to benefit from falling rates. Swaps, FRAs and futures lock in the outcome both ways.
- APay-fixed interest rate swap
- BBuying an interest rate capCorrect
- CSelling interest rate futures with no option
- DBuying an FRA
Explanation
A cap sets a maximum rate for the upfront premium while allowing the borrower to benefit from falling rates. Swaps, FRAs and futures hedges are binding and remove the favourable movement.
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