ACCA Financial Management (F9) Certification Practice Exam

Which instrument allows parties to exchange interest rate commitments while managing risk?

1. Interest rate options

2. Interest rate swap

3. Interest rate futures

4. Forward Rate Agreement (FRA)

The correct answer is: Interest rate swap

The instrument that allows parties to exchange interest rate commitments while managing risk is the interest rate swap. In a typical interest rate swap, two parties agree to exchange interest payments on a specified principal amount, which is not actually exchanged. This allows one party to pay a fixed interest rate while receiving a variable (or floating) rate, or vice versa. This structure is advantageous for managing interest rate risk because it enables organizations to tailor their exposure to interest rate fluctuations according to their specific needs. For example, a company with a floating-rate loan may enter into a swap to convert it to fixed payments, thus securing predictability in cash flows and protecting against rising interest rates. On the other hand, a company that has fixed-rate debt might want to leverage floating rates to take advantage of potentially lower variable payments. Interest rate options, futures, and forward rate agreements serve different purposes in managing risk. Options provide the right, but not the obligation, to exchange payments or rates, which introduces a degree of flexibility but does not fit the definition of an instrument purely for exchange like a swap. Futures involve standardized contracts traded on exchanges, which do not allow for direct negotiation between parties about the terms of the interest rate exchange. Forward Rate Agreements are agreements to lock in an