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

A company with floating-rate debt enters a pay-fixed interest rate swap. Which statement best describes the risk the company retains after the swap, assuming the swap rate is fixed and notional equals the loan?

The company retains the opportunity cost if floating rates fall below the fixed swap rate. A pay-fixed swap removes the exposure to rising rates but obliges the company to keep paying the fixed rate, so it cannot benefit from lower market rates, unlike an interest rate option.

  1. AOpportunity cost if market floating rates fall below the fixed swap rateCorrect
  2. BExposure to a rise in floating rates on the loan
  3. CExposure to changes in the loan margin only if rates rise
  4. DExposure to rising rates offset by a premium paid upfront

Explanation

A pay-fixed swap locks in the rate, so the company no longer suffers from rate rises, but it cannot benefit if rates fall and must still pay the fixed rate, so it bears opportunity cost. Unlike an option, no upfront premium is paid and there is no one-sided protection.

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