ACCA Financial Management (F9) Certification Practice Exam

When a borrower buys an interest rate cap while simultaneously selling an interest rate floor, what is this arrangement called?

1. Interest rate collar

2. Interest rate swap

3. Interest rate options

4. Forward Rate Agreement (FRA)

The correct answer is: Interest rate collar

The arrangement described involves a borrower purchasing an interest rate cap while concurrently selling an interest rate floor. This strategy is known as an interest rate collar. An interest rate collar is used to limit the range of interest rates that a borrower might face. By buying an interest rate cap, the borrower ensures that their interest payments will not exceed a certain upper limit, which is defined by the cap's strike rate. On the other hand, by selling an interest rate floor, the borrower relinquishes the right to benefit from falling interest rates below a certain level, which sets a lower limit on the interest they will pay. Combining these two instruments creates a band or "collar" around the interest rates—hence the name—thereby allowing the borrower to manage their interest rate exposure more effectively while potentially reducing the cost of hedging. This strategy is particularly useful for borrowers who want to create certainty around their future interest payments, as it mitigates the risks associated with rising interest rates while still benefiting from potentially lower rates within the defined range. In contrast, an interest rate swap involves exchanging fixed and floating interest payments between two parties, while interest rate options generally refer to standalone options without the simultaneous selling of another option. A forward rate agreement is a