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

Which of the following is a recognised limitation of using an FRA to hedge interest rate risk, compared with an interest rate option such as a cap or guarantee?

The main limitation is that an FRA locks in the rate, so the user cannot benefit from favourable rate movements. It is binding, unlike an option, which can be abandoned. FRAs are over-the-counter, tailored and carry no upfront premium.

  1. AAn FRA requires payment of an upfront premium whatever the rate outcome
  2. BAn FRA is exchange-traded with standardised amounts and dates, so it rarely matches the exposure
  3. CAn FRA locks in the rate, so the user cannot benefit if rates move favourablyCorrect
  4. DAn FRA cannot be used to hedge a floating-rate borrowing

Explanation

An FRA is a binding agreement that fixes the rate, so the user loses the benefit of favourable movements; options give a right not an obligation. FRAs are OTC and tailored, with no upfront premium, and they can hedge floating-rate exposures. Premiums and standardisation are features of options and futures.

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