Skip to content

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

Delta Ltd has a $50 million floating rate loan at SOFR + 1.0%. It can swap with a bank: pay fixed 4.0% and receive SOFR. Alternatively it can buy a cap at a strike of 4.0% costing $250,000 upfront, with no other cost. SOFR is 5.5% for a full year. Ignoring time value and tax, which statement comparing the year's net cost is correct?

The swap costs $2.5 million, being 5% on $50 million. The cap costs $2.75 million: loan interest of $3.25 million less a $0.75 million cap payout, plus the $0.25 million premium. In this scenario the swap is cheaper because rates rose only moderately and the premium is lost.

  1. ASwap total cost $2.5m; cap total cost $2.75mCorrect
  2. BSwap total cost $2.5m; cap total cost $2.5m
  3. CSwap total cost $2.25m; cap total cost $2.5m
  4. DSwap total cost $3.25m; cap total cost $2.75m

Explanation

With the swap, Delta pays SOFR + 1% on the loan, receives SOFR and pays 4.0%, so 5.0% x $50m = $2.5m. With the cap, the payout is (5.5% - 4.0%) x $50m = $750,000, so loan interest of 6.5% x $50m = $3.25m less $0.75m = $2.5m, plus $0.25m premium = $2.75m. Option B ignores the premium.

Did you get it right without looking?

One question tells you little. A timed set on The use of financial derivatives to hedge against interest rate risk shows your real accuracy, how long you take and where you lose marks.

Practise The use of financial derivatives to hedge against interest rate riskFree diagnostic mock

More The use of financial derivatives to hedge against interest rate risk questions