ACCA Financial Management (F9) Certification Practice Exam

What financial instrument allows for the management of interest rate exposure by agreeing on a fixed interest rate for a specified future period?

1. Forward Rate Agreement (FRA)

2. Interest rate collar

3. Interest rate cap

4. Interest rate floor

The correct answer is: Forward Rate Agreement (FRA)

The Forward Rate Agreement (FRA) is a financial instrument specifically designed to manage interest rate exposure by allowing two parties to agree on a fixed interest rate for a future period. This arrangement is particularly useful for businesses and financial institutions that want to hedge against fluctuations in interest rates. When two parties enter into an FRA, they agree on a specified notional amount, a fixed interest rate, and a future settlement date. On that date, the difference between the agreed fixed rate and the market interest rate will determine the cash flows exchanged between the parties. If the market rate exceeds the fixed rate, one party pays the other the difference, effectively insulating them from rising interest costs. Conversely, if the market rate is lower than the fixed rate, the fixed-rate payer is effectively compensated for the higher cost they are incurring. This instrument provides certainty and predictability regarding interest payments, which is crucial for financial planning and risk management. By locking in a fixed rate, companies can mitigate the risk of rising interest rates impacting their borrowing costs. Other instruments like interest rate collars, caps, and floors have different functionalities. An interest rate cap allows for a maximum interest rate on a floating rate debt, while a floor provides a minimum interest rate. An interest rate collar combines