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Risk ManagementSection ARisk ManagementInterest Rate RiskDerivatives

ACCA · Question 08 · Risk Management

Section A

CryptoVault Exchange is concerned that interest rates on its fiat currency borrowings will rise over the next six months. The treasury team is deciding between a Forward Rate Agreement (FRA) and an Interest Rate Guarantee (IRG).

Which of the following statements is true regarding these hedging instruments?

Answer options:

A.

An FRA requires the payment of an upfront premium, whereas an IRG does not.

B.

An IRG protects against adverse interest rate movements while allowing the company to benefit from favorable movements, whereas an FRA fixes the rate entirely.

C.

Both FRAs and IRGs are traded on standardized futures exchanges.

D.

An FRA allows the borrower to abandon the contract if interest rates fall, whereas an IRG is a binding commitment.

How to approach this question

Understand the difference between a forward contract (binding, fixes the rate) and an option (right but not obligation, protects downside but keeps upside). An IRG is an option on an FRA.

Full Answer

B.An IRG protects against adverse interest rate movements while allowing the company to benefit from favorable movements, whereas an FRA fixes the rate entirely.✓ Correct
A Forward Rate Agreement (FRA) is a binding contract that fixes the interest rate, meaning the company cannot benefit if rates move in their favor. An Interest Rate Guarantee (IRG) is an option on an FRA; it protects the company from adverse rate movements but allows them to let the option lapse and borrow at the market rate if rates fall. Because of this flexibility, an IRG requires an upfront premium.

Common mistakes

Confusing the characteristics of forwards (binding) with options (flexible).
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