Interest rate risk and derivatives - FRAs, futures, and opti...

Learning Outcomes

After reading this article, you will be able to identify different types of interest rate risk, explain how forward rate agreements (FRAs), interest rate futures, and options are used to manage such risk, and assess which hedging technique is appropriate in various exam scenarios.

ACCA Financial Management (FM) Syllabus

For ACCA Financial Management (FM), you are required to understand interest rate risk and the main hedging techniques available to manage it. In particular, this article focuses on:

• Types of interest rate risk, such as gap and basis risk, and their implications for businesses
• The basic structure and use of forward rate agreements (FRAs), including calculation of settlements
• The purpose and mechanics of interest rate futures and associated hedging strategies
• The use of options (caps, floors, collars) for interest rate risk management
• How to select and evaluate appropriate hedging methods in exam-based scenarios

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which derivative locks in a future borrowing or lending rate but requires the contract to be honored even if interest rate movements would have favored the business?
   1. Option
   2. Forward rate agreement (FRA)
   3. Spot contract
   4. Collateralized deposit
2. When does basis risk arise in the context of interest rate futures?
   1. When settlement dates differ between the loan and the future
   2. When a company enters an FRA
   3. When only options are used
   4. When loans are fixed-rate

3. True or false? A cap option sets a minimum interest rate that a lender will receive.

4. Briefly explain the main advantage of an interest rate option compared to an FRA for a firm uncertain about future borrowing needs.

Introduction

Interest rate risk is the uncertainty regarding future interest payments or receipts due to fluctuations in interest rates. Most businesses are exposed to this risk either when borrowing at variable rates or when investing surplus cash. The ability to manage this risk is central to financial management. This article reviews the main types of interest rate risk and focuses on common derivative instruments available to hedge exposures: forward rate agreements (FRAs), interest rate futures, and options. Understanding how each hedge works, and when to use them, is frequently tested in the ACCA FM exam.

Key Term: interest rate risk
The potential impact on a business’s cash flows and profitability due to unexpected changes in market interest rates.

Identifying Interest Rate Risk

Interest rate risk arises whenever a business’s cash flows depend on floating (variable) interest rates or if refinancing will occur in the future. The risk may relate to:

• The cost of existing or planned variable-rate loans
• Future investment returns on surplus funds
• The value of fixed-income securities held by the business

Key Term: gap exposure
Exposure resulting from mismatches in timing between the repricing dates of a firm’s interest-sensitive assets and liabilities.

Key Term: basis risk
The risk that changes in interest rates on a hedged item and the associated hedge instrument do not move exactly in line, leading to imperfect hedges.

Managing Interest Rate Risk

Financial managers seek to limit the negative impact of rising borrowing costs or falling investment returns. The three main derivative tools for hedging interest rate risk at FM level are FRAs, futures, and options.

Forward Rate Agreements (FRAs)

An FRA is a contract between a firm and a bank that locks in a specified interest rate for a future period. The contract settles in cash and compensates one party if the actual market rate deviates from the agreed rate during the covered period.

Key Term: forward rate agreement (FRA)
An over-the-counter contract that fixes the interest rate applicable to a notional borrowing or deposit for a future period.

Main points:

• Specifies the notional amount, future period, and agreed rate
• At settlement, a cash payment reflects the difference between the agreed FRA rate and the actual market rate
• Used to hedge future borrowings (buy FRA) or investments (sell FRA)

Interest Rate Futures

Interest rate futures are standardized contracts traded on exchanges that allow participants to lock in future short-term interest rates. They are settled daily (marked to market) and are typically used to hedge exposure to uncertain future rates.

Key Term: interest rate futures
Standardized exchange-traded contracts to buy or sell a notional amount of debt at a specified interest rate on a future date.

Hedging with futures:

• To hedge a future borrowing, sell interest rate futures contracts now and buy them back at close-out (BS rule: Borrowing—Sell)
• To hedge a future deposit, buy futures now and sell later (DB rule: Deposit—Buy)
• Profit or loss on the futures contract offsets changes in borrowing or investment costs

Key Term: basis risk
The possibility that the change in value of the hedge instrument (future) does not perfectly offset the exposure due to timing mismatches or differences in reference rates.

Options (Caps, Floors, Collars)

Interest rate options give the right, but not the obligation, to fix or limit interest rates for a fee (premium). This additional flexibility is valuable when future needs or exposures are uncertain.

Key Term: interest rate option
A contract giving the holder the right but not the obligation to fix or limit the interest rate for a period, usually by means of a cap (maximum) or floor (minimum) arrangement.

• Caps: Set a maximum (cap) interest rate for borrowers (protects against rising rates)
• Floors: Set a minimum rate for investors (protects against falling returns)
• Collars: Combination of cap and floor contracts, establishing both upper and lower rate limits

Comparing Hedging Methods

Worked Example 1.1

A company expects to borrow $2 million in three months' time for six months and is worried that interest rates may rise. An FRA is available today at 4.0%. If the actual 6-month LIBOR in three months is 5.2%, how does the FRA protect the company?

Answer:
The company enters into a 3–9 FRA at 4.0%. If in three months the 6-month LIBOR is 5.2%, the company must pay interest at 5.2% on the loan but will receive a compensating payment from the FRA counterparty. The payment equals the interest difference on $2 million for six months discounted back to present value. The net effect is that the effective cost of borrowing is locked at 4.0%.

Worked Example 1.2

A business needs to hedge a forecast $5 million, 6-month floating rate investment due to start in two months. Should the treasurer buy or sell interest rate futures to hedge against falling rates?

Answer:
The business is at risk if rates fall (lower returns). To hedge a deposit, the business buys interest rate futures now (DB rule). If interest rates fall, the gain on the bought futures contract compensates for the lower interest revenue on the cash investment.

Worked Example 1.3

A borrower purchases an interest rate cap with a strike rate of 6% for a premium. If market rates rise to 8% during the period, what does the cap achieve?

Answer:
The cap ensures the borrower pays no more than 6% on their floating-rate loan, as the option will be exercised. If rates had remained below 6%, the borrower would simply have allowed the option to lapse, paying floating rates plus the cap premium.

Exam Warning

Always check whether the exam scenario exposure is a future loan or investment. The correct hedge (buy vs. sell futures) depends on whether you're managing borrowing or depositing risk.

Revision Tip

If in doubt about futures hedging direction, remember the BS/DB rule: Borrowing—Sell, Deposit—Buy.

Summary

Interest rate risk can impact both borrowing costs and investment returns. FM candidates must be able to identify the exposure, choose the relevant hedging tool (FRA, future, option), and explain how each manages specific risks. Understanding the mechanics of each derivative—settlement, direction, and potential basis risk—is essential for exam success.

Key Point Checklist

This article has covered the following key knowledge points:

• Define and identify types of interest rate risk, including gap and basis risk
• Explain the structure and use of forward rate agreements (FRAs)
• Describe how interest rate futures work, and determine buy/sell decisions
• Outline the purpose and operation of interest rate options (caps, floors, collars)
• Understand the strengths and limitations of each hedging method
• Apply these techniques to exam scenarios to advise on appropriate risk management

Key Terms and Concepts

• interest rate risk
• gap exposure
• basis risk
• forward rate agreement (FRA)
• interest rate futures
• interest rate option