ACCA Financial Management (F9) Certification Practice Exam

Which financial agreement is considered a forward contract on interest rates?

1. Interest rate cap

2. Forward Rate Agreement (FRA)

3. Interest rate collar

4. Interest rate options

The correct answer is: Forward Rate Agreement (FRA)

A Forward Rate Agreement (FRA) is indeed considered a forward contract on interest rates. It is a financial derivative that allows two parties to lock in an interest rate for a future period on a notional amount. This means that the agreement specifies an interest rate that one party will pay and the other will receive at a specified future date, based on the notional principal. The significance of FRAs lies in their ability to hedge against interest rate fluctuations. By entering into an FRA, companies can effectively plan and budget for future interest expenses or income, reducing their exposure to uncertain movements in interest rates. This characteristic of locking in rates aligns closely with the concept of a forward contract, which is fundamentally a commitment to transact at a future date with pre-defined terms. In contrast, other options like interest rate caps and collars do not meet the definition of a forward contract because they do not involve a strict agreement to pay or receive interest at a future point in time based solely on a predetermined rate. Instead, caps and collars serve as protective instruments that establish upper (cap) or upper and lower (collar) limits on interest rates, thus offering flexibility rather than a fixed contractual obligation. Interest rate options also grant the right, but not the obligation, to