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

Alpha plc has a floating-rate loan at SOFR + 1.00% and wants certainty of interest cost. It enters a pay-fixed, receive-floating interest rate swap with a bank at a fixed rate of 4.00% against SOFR. Ignoring counterparty and basis risk, what is Alpha's effective annual interest rate on the loan?

The effective rate is 5.00%. The floating SOFR received on the swap offsets the SOFR paid on the loan, leaving the 1.00% loan margin plus the 4.00% fixed swap rate, so Alpha has a fixed cost of 5.00% regardless of rate movements.

  1. A5.00%Correct
  2. B3.00%
  3. C4.00%
  4. DSOFR + 5.00%

Explanation

Alpha pays SOFR + 1.00% on the loan, receives SOFR from the swap and pays 4.00% fixed. Net cost = SOFR + 1.00% - SOFR + 4.00% = 5.00%. The 3.00% option wrongly subtracts the fixed leg, and 4.00% ignores the loan margin.

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