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

A company will borrow $8 million for 3 months starting in 2 months. It can use an FRA at 4.5% or buy 3-month interest rate futures puts. Which is the main reason the futures hedge is usually less than perfect?

Exchange-traded futures have standard contract sizes and maturity dates, so the hedge may not match the exposure exactly, and basis risk means futures prices may not move perfectly with the cash rate. Margin and daily marking to market also apply, which makes the other statements incorrect.

  1. ABasis risk and standard contract sizes and datesCorrect
  2. BFutures lock the rate with no margin required
  3. CFutures settle only at maturity with no daily flows
  4. DFutures have no price risk

Explanation

Futures are standardised in size and maturity, so the hedge may be rounded to whole contracts and dates may not match; the futures price may also not converge precisely with the spot rate, leaving basis risk. Futures require margin and are marked to market daily, so the other options are false.

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