RISK MANAGEMENT

1. INTRODUCTION TO FOREIGN EXCHANGE RISK

Definition: Foreign exchange (FX) risk is the risk that exchange rate movements will adversely
affect the value of foreign currency transactions, assets, or liabilities.

Why it matters for FM:

• Affects companies engaged in international trade (importing/exporting)

• Impacts overseas investments and foreign subsidiaries
• Can significantly affect profitability and cash flows
• Requires active management through hedging strategies
Key principle (ACCA Technical Article): Transaction risk management is NOT mainly concerned
with achieving the most favorable cash flow – it is mainly aimed at achieving a definite cash flow.
Only then can proper planning be undertaken.

2. TYPES OF FOREIGN EXCHANGE RISK

There are three main types of currency risk:

2.1 Transaction Risk

Definition: Risk arising when a company has to settle a transaction at a future date at an exchange
rate different from the rate when the contract was agreed.

When it occurs: Between the time a foreign currency transaction is agreed and when cash is actually
paid or received.

Example from ACCA Technical Article:

• June: UK company agrees to sell export to Australia for A$100,000, payable in 3 months
• Current exchange rate: A$/£1.80
• Expected receipt: A$100,000 ÷ 1.80 = £55,556
• If A$ weakens to A$/£2.00 by September:
o Actual receipt: A$100,000 ÷ 2.00 = £50,000
o Loss: £5,556
Impact: Creates uncertainty in home currency cash flows from foreign currency transactions.

Most relevant to: Companies importing or exporting goods/services.

2.2 Translation Risk (Consolidation Risk)

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Definition: Risk arising when a company translates the financial statements of foreign subsidiaries
into the home currency for consolidation.

When it occurs: At each reporting date when foreign subsidiary results are consolidated into group
accounts.

How it works:

• Foreign subsidiary has assets and liabilities denominated in foreign currency

• When foreign currency weakens, the translated value in home currency falls
• Affects reported group assets, liabilities, and profits
Caveat: Translation risk becomes real if:

• Holding company wants to sell subsidiary and remit proceeds

• Subsidiary pays dividends to parent
Most relevant to: Multinational groups with foreign subsidiaries.

2.3 Economic Risk (Competitive Risk)

Definition: Risk arising from changes in exchange rates affecting a company's competitive position
and long-term cash flows.

When it occurs: When exchange rate movements change the competitiveness of imports and
exports over the long term.

Example from ACCA Technical Article:

UK exporter to Eurozone:

• Euro weakens from €/£1.1 to €/£1.3

• UK goods priced at £100 now cost:
o Before: €110
o After: €130
• Result: UK exports more expensive in Europe → less competitive
Conversely:

• Goods imported from Europe become cheaper in sterling

• European competitors more competitive in UK market
Key point: A company can experience economic risk even if it has no overt dealings with
overseas countries. If competing imports could become cheaper, you are suffering economic risk.
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Mitigation strategies (ACCA Technical Article):

1. Diversify currency exposure: Export/import from multiple currency zones (hope they don't
all move together)
2. Natural hedging: Manufacture goods in the country where you sell them (local wages/costs
in local currency, only raw materials subject to FX risk)
Impact: Long-term strategic effects on competitiveness, market share, and profitability.

Most relevant to: All companies facing international competition.

3. CAUSES OF EXCHANGE RATE FLUCTUATIONS

Understanding what drives exchange rates helps predict future movements and inform hedging
decisions.

3.1 Balance of Payments

Definition: Record of all economic transactions between a country and the rest of the world.

Components:

• Current Account: Trade in goods/services, investment income, transfers

• Capital & Financial Account: Foreign direct investment, portfolio investment
Effect on exchange rates:

Balance of Payments Position Effect on Currency

Current account surplus (exports > imports) Currency appreciates (strengthens)
Current account deficit (imports > exports) Currency depreciates (weakens)

Why?

• Surplus → High demand for country's currency (to buy exports) → Currency strengthens
• Deficit → High supply of country's currency (to buy imports) → Currency weakens

3.2 Relative Interest Rates

Relationship: Higher interest rates attract foreign investment → Currency appreciates

Why?

• Higher rates → Better returns on deposits/bonds

• Foreign investors buy currency to invest
• Increased demand → Currency strengthens
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Example:

• UK interest rates rise from 2% to 4%

• US rates remain at 2%
• Foreign investors buy £ to deposit in UK banks
• £ appreciates against $

3.3 Relative Inflation Rates

Relationship: Higher inflation → Currency depreciates (Purchasing Power Parity theory)

Why?

• High inflation → Goods become more expensive → Exports less competitive

• Reduced demand for exports → Reduced demand for currency
• Currency weakens
Example:

• UK inflation: 5% p.a.
• US inflation: 2% p.a.
• UK goods become relatively more expensive
• £ expected to depreciate against $

3.4 Other Factors

Political stability:

• Political uncertainty → Currency weakens (capital flight)

• Stable government → Currency strengthens
Speculation:

• Market expectations drive short-term movements

• Self-fulfilling prophecies common
Economic growth:

• Strong growth → Currency appreciation

• Attracts foreign investment

4. EXCHANGE RATE THEORIES AND FORECASTING

4.1 Purchasing Power Parity (PPP) Theory

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Definition: Exchange rates adjust to equalize the purchasing power of currencies (keep real prices of
goods equal across countries).

Formula:
1 + ℎ𝑐
𝑆1 = 𝑆0 ×
1 + ℎ𝑏

Where:

• 𝑆0 = Current spot rate (home currency per unit of foreign currency)

• 𝑆1 = Expected future spot rate
• ℎ𝑐 = Inflation rate in foreign (counter) currency country
• ℎ𝑏 = Inflation rate in home (base) currency country
Illustration 1: PPP Calculation

Given:

• Current spot rate: $/£1.50 (1 pound = 1.50 dollars)

• US inflation: 3% p.a.
• UK inflation: 5% p.a.
Required: Expected spot rate in one year.

Solution:
1.03
𝑆1 = 1.50 × = 1.50 × 0.9810 = $1.4715/£
1.05
Interpretation: £ expected to weaken (depreciate) from $1.50 to $1.4715 because UK has higher
inflation.

Key insight: Currency with higher inflation expected to depreciate.

4.2 Interest Rate Parity (IRP) Theory

Definition: The difference between spot and forward exchange rates is determined by relative
interest rates between two countries.

Formula:
1 + 𝑖𝑐
𝐹0 = 𝑆0 ×
1 + 𝑖𝑏

Where:

• 𝐹0 = Forward rate
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• 𝑆0 = Current spot rate

• 𝑖𝑐 = Interest rate in foreign currency country
• 𝑖𝑏 = Interest rate in home currency country
Illustration 2: IRP Calculation

Given:

• Current spot rate: €/£1.20

• Eurozone interest rate: 2% p.a.
• UK interest rate: 4% p.a.
Required: 1-year forward rate.

Solution:
1.02
𝐹0 = 1.20 × = 1.20 × 0.9808 = €1.177/£
1.04
Interpretation: £ trades at a forward discount (1.177 < 1.20) because UK has higher interest rates.

Key insight: Currency with higher interest rate trades at a forward discount (expected to
weaken).

Why? Higher rates compensate for expected currency depreciation.

4.3 Four-Way Equivalence

Concept: Links inflation, interest rates, spot rates, and forward rates in an integrated framework.

Relationships:

Four-Way Equivalence Model

𝑆 1+ℎ
(1) PPP: 𝑆1 = 1+ℎ𝑐 (Inflation differences explain future spot rate changes)
0 𝑏
𝐹 1+𝑖
(2) IRP: 𝑆0 = 1+𝑖 𝑐 (Interest rate differences explain forward premium/discount)
0 𝑏
1+𝑖
(3) Fisher Effect: 1+𝑟 = 1 + ℎ (Nominal interest rate = real rate + inflation)
(4) Expectations Theory: 𝐹0 = 𝐸(𝑆1 ) (Forward rate is unbiased predictor of future spot rate)
Combined result: All four variables (spot rates, forward rates, inflation, interest rates) are
interconnected.

Practical use:

• Use PPP to forecast future spot rates

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• Use IRP to calculate forward rates

• Forward rate gives indication of expected future spot rate

5. READING EXCHANGE RATE QUOTATIONS

Critical exam skill: Correctly interpreting quoted exchange rates.

5.1 Direct vs. Indirect Quotes

Direct Quote

When base currency is foreign currency, it is called Direct Quote.

If USD 1 = NPR 130, it's a direct quote for someone in Nepal.

Indirect Quote

When base currency is home currency, it is indirect quote.

If NPR 1 = USD 0.0077, it's an indirect quote.

Conversion (Multiply or Divide)

If foreign exchange, when converting between currencies, we follow a Multiply or Divide rule based
on whether we are converting from Base currency to other currency or vice versa.

• If converting base currency to other currency- Multiply

• If converting other currency to base currency- Divide

5.2 Bid-Offer Spreads (Two-Way Quotes)

Banks always quote two rates:

Bank's Perspective Customer's Perspective

Bid rate Rate at which bank buys foreign currency Rate at which you sell foreign currency

Offer (Ask) rate Rate at which bank sells foreign currency Rate at which you buy foreign currency

Key rule: Bank always gives you the worse rate (wider spread = bank profit).

Example:

Quote: €/£ 1.1500 – 1.1530

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Scenario 1: UK company receiving €500,000 (selling € to bank)

• Use bid rate (1.1500)

• £ received = €500,000 ÷ 1.1500 = £434,783
Scenario 2: UK company paying €500,000 (buying € from bank)

• Use offer rate (1.1530)

• £ paid = €500,000 ÷ 1.1530 = £433,651
Memory aid: "Buy high, sell low" (from your perspective – bad for you, good for bank).

5.3 Forward Rates

Forward rates can be quoted:

1. Directly: €/£ 3-month forward 1.1480 – 1.1510

2. As premium/discount to spot:
Example:

Spot: €/£ 1.1500 – 1.1530

3-month forward: 20 – 10 premium

Interpretation of premium/discount:

• Premium: Forward rate > Spot rate (currency strengthening)

• Discount: Forward rate < Spot rate (currency weakening)
Calculation:

• If numbers descending (20 – 10): Add to spot to get forward

• If numbers ascending (10 – 20): Subtract from spot to get forward
Apply the rule:

• Bid: 1.1500 + 0.0020 = 1.1520

• Offer: 1.1530 + 0.0010 = 1.1540
• Forward quote: €/£ 1.1520 – 1.1540
Examiner tip: Always show your working when calculating forward rates from
premiums/discounts.

6. INTERNAL (NATURAL) HEDGING TECHNIQUES

Philosophy: Manage FX risk using operational strategies rather than financial instruments.

Advantages:
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• No external costs (no bank fees, premiums)

• Simple to implement
• Part of normal business operations
Disadvantages:

• May not eliminate all risk

• Not always feasible
• May conflict with commercial objectives

6.1 Invoicing in Home Currency

Method: Negotiate contracts and invoice in your own currency.

Effect: Shifts all exchange rate risk to the other party.

Example:

• UK exporter invoices Australian customer in £ (not A$)

• UK company receives known £ amount
• Australian customer bears the FX risk
Limitations:

• Customer may resist (prefer their own currency)

• May lose competitive advantage if competitors invoice in customer's currency
• Not feasible if customer has strong negotiating position
Best used when: Seller has strong market position or product differentiation.

6.2 Netting
Definition: Offsetting foreign currency receipts and payments within a group to reduce net exposure.

Types:

Bilateral netting: Two group companies offset their mutual payables/receivables

Example:

• UK parent owes Japanese supplier ¥1,000,000

• Japanese subsidiary owes UK parent ¥1,100,000
• Net exposure: Only ¥100,000 (reduce FX risk by 95%)
Multilateral netting: Many group companies coordinate through central treasury

Process:
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1. Each subsidiary reports expected receipts and payments in each currency

2. Treasury calculates net group position in each currency
3. Only net amounts hedged or transacted externally
Benefits:

• Reduces transaction costs (fewer currency conversions)

• Reduces FX exposure
• Simplifies cash management
Requirements:

• Needs many transactions in same currency

• Works best with centralized treasury function
• Transactions should be close together in time (not separated by many months)

6.3 Matching
Definition: Using foreign currency bank accounts to match receipts and payments in the same
currency.

Example from ACCA Technical Article:

• 1 Nov: Receive $2m from US customer → Deposit in $ bank account

• 15 Nov: Pay $1.9m to US supplier → Pay from $ account
• Net exposure: Only $0.1m
Benefits:

• Eliminates FX risk on matched portion

• Avoids unnecessary currency conversions
• Reduces transaction costs
Limitations:

• Requires many import/export transactions

• Timing of receipts and payments must be close
• Not feasible if large time gap (e.g., receive $2m in Nov, pay $1.9m in May – most businesses
can't hold foreign currency for months)
Best used when: Company has regular, frequent transactions in same foreign currency.

6.4 Leading and Lagging

Definition:
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• Leading: Paying (or receiving) earlier than required

• Lagging: Paying (or receiving) later than required
When to use:

Action When Effect

Lead receipts Expect foreign currency to weaken Receive foreign currency now before it loses value

Lag receipts Expect foreign currency to strengthen Receive foreign currency later when it's worth more

Lead payments Expect foreign currency to strengthen Pay now before currency becomes more expensive

Lag payments Expect foreign currency to weaken Pay later when currency is cheaper

Example from ACCA Technical Article:

• Planning trip to Spain, expect € to strengthen

• Lead: Change money to € now (before € becomes more expensive)
• Know exact cost in home currency
ACCA Technical Article Warning:
"Leading and lagging does NOT reduce risk because you still do not know your costs. Lagging is
simply taking a gamble that your hunch about currency movement is correct."

Key distinction:

• Leading when expecting currency to move against you: Reduces risk (locks in current rate)
• Lagging: Speculation (could go wrong – currency might move against you)
Limitations:

• May annoy suppliers/customers

• Opportunity cost of early payment
• May violate credit terms

6.5 Asset and Liability Management

Method: Match foreign currency assets with foreign currency liabilities.

Application for translation risk (covered earlier):

• Fund foreign subsidiary with foreign currency loan

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• Reduces net foreign currency exposure

Application for transaction risk:

• Hold foreign currency deposits to fund future foreign currency payments

• Borrow foreign currency now if expecting future foreign currency receipts
Example:

• UK company will receive $5m in 6 months

• Borrow $X now (calculate amount that grows to $5m with interest)
• Convert $X to £ immediately at spot rate
• Repay loan with $5m receipt in 6 months
This is the basis of money market hedging (covered next section).

Key points

• Always solve from the customer’s perspective

• Use higher rate (Ask Price) for buying base currency and lower rate (Bid Price) for
selling.
• Use lower rate (Bid price) for buying other currency and higher rate (Ask Price) for
selling.
• Multiply when converting base currency into other currency.
• Divide when converting other currency into base currency.

7. EXTERNAL HEDGING TECHNIQUES

When to use: Internal hedging insufficient or not feasible.

7.1 Forward Exchange Contracts

Definition: Binding agreement to exchange currencies at a specified future date at an agreed rate
(the forward rate).

Key features:

• Binding obligation (must fulfill contract)

• Customizable (amount, date, currencies)
• No upfront cost
• OTC (Over-the-counter – arranged with bank)
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• Fixes exchange rate (certainty achieved)

Illustration 3: Forward Contract (Export)

Scenario:

• Italian exporter selling to UK for £500,000, receivable in 3 months

• Current spot rate: €/£ 1.2022 – 1.2028
• 3-month forward rate: €/£ 1.2014 – 1.2026
Which rate to use?

• Exporter will sell £ to bank in 3 months (convert to €)

• Use bank's bid rate (bank buys £ at lower rate)
• Forward rate: 1.2014
Contract: In 3 months, deliver £500,000, receive €600,700 (£500,000 × 1.2014)

Outcome:

• €600,700 guaranteed, regardless of spot rate in 3 months

• Certainty achieved ✓
What if £ strengthens to €/£ 1.50?

• Without hedge: Would have received €750,000

• With forward: Locked in at €600,700
• Opportunity cost: €149,300
ACCA Principle: "Income maximization is not the point of hedging – its point is to provide
certainty."

Illustration 4: Forward Contract (Import)

Scenario:

• UK importer buying from US for $1,000,000, payable in 6 months

• Spot rate: $/£ 1.3000 – 1.3020
• 6-month forward rate: $/£ 1.2950 – 1.2970
Which rate to use?

• Importer will buy $ from bank in 6 months

• Use bank's offer rate (bank sells $ at higher rate)
• Forward rate: 1.2950
Contract: In 6 months, pay £772,201 ($1,000,000 ÷ 1.2950), receive $1,000,000
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Outcome:

• £772,201 cost guaranteed

• Budgeting certainty ✓
Advantages:

• No upfront premium
• Fixes rate (certainty)
• Customizable
• Straightforward
Disadvantages:

• Binding obligation (can't benefit from favorable rate movements)

• Counterparty risk (bank might default – low risk with major banks)
• Closing out risk: If underlying transaction falls through, must still fulfill forward
contract

7.2 Money Market Hedging

Definition: Using borrowing and lending in foreign and domestic money markets to create a hedge.

Principle: Create a foreign currency liability (if receiving foreign currency) or asset (if paying
foreign currency) to match the future transaction.

Illustration 5: Money Market Hedge (Receiving Foreign Currency)

Scenario:

• UK exporter will receive $2,000,000 in 3 months

• Current spot rate: $/£ 1.4701
• US$ 3-month interest rate (borrowing): 0.66% p.a.
• UK£ 3-month deposit rate: 1.2% p.a.
Objective: Convert future $2m receipt to known £ amount today.

Steps:

Step 1: Borrow $X now (such that with 3 months' interest, it grows to $2,000,000)
0.66%
𝑋 × (1 + ) = 2,000,000
4
2,000,000
𝑋= = $1,996,705
1.00165
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Step 2: Convert $1,996,705 to £ at spot rate

1,996,705
£ received = = £1,358,210
1.4701
Step 3: Deposit £1,358,210 for 3 months at 1.2% p.a.
1.2%
Future value = 1,358,210 × (1 + ) = £1,362,285
4
Step 4: In 3 months, receive $2m from customer, repay $ loan

Result: £1,362,285 received (after depositing for 3 months)

Key insight: Money market hedge gives £ now (or known future £ amount). Can compare to
forward contract by calculating future value.

Illustration 6: Money Market Hedge (Paying Foreign Currency)

Scenario:

• UK importer will pay €800,000 in 4 months

• Spot rate: €/£ 1.1500
• €4-month deposit rate: 1.0% p.a.
• £4-month borrowing rate: 2.5% p.a.
Objective: Lock in £ cost today.

Steps:

Step 1: Calculate €X to deposit now (grows to €800,000 in 4 months)

1.0%
𝑋 × (1 + × 4) = 800,000
12
800,000
𝑋= = €797,352
1.00333
Step 2: Convert £ to € at spot rate
797,352
£ needed = = £693,393
1.1500
Step 3: Borrow £693,393 at 2.5% p.a. for 4 months

Future liability:
2.5%
693,393 × (1 + × 4) = £699,165
12
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Step 4: In 4 months, € deposit matures to €800,000, pay supplier

Result: £699,165 cost (future value of borrowing)

Advantages of money market hedging:

• Receive/pay in home currency immediately (can use funds now)

• Fixes exchange rate
• Eliminates FX risk
Disadvantages:

• Complex (multi-step process)

• Requires access to foreign currency borrowing/lending markets
• Interest costs/opportunity costs
Comparing forward contract to money market hedge:

Key rule: Must compare on like-for-like basis (same timing).

• Forward contract: Receipt/payment in X months

• Money market hedge: Receipt/payment now (or calculate future value)
To compare:

1. Calculate net receipt from forward contract

2. Calculate net receipt from money market hedge (deposit for X months if receiving now)
3. Choose method giving better outcome
Examiner feedback: Candidates often forget to calculate future value when comparing methods.
Always adjust for time value of money.

7.3 Currency Futures

Definition: A legal agreement to buy or sell a particular commodity asset, or security at a
predetermined price at a specified time in the future.

However, unlike forwards, this is achieved by entering into a futures contract that is separate from
the actual transaction and operates in such a way that if you make a loss in the spot market, you will
expect to make a profit in the futures market (and vice-versa).

Key features:

• Exchange-traded (not OTC)

• Standardized contracts (fixed sizes, maturity dates)
• Clearinghouse guarantee (no counterparty risk)
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• Marked to market daily (margin requirements)

Compared to forward contracts:

Feature Forward Contract Currency Futures

Market OTC (bank) Exchange-traded
Customization Fully customizable Standardized
Counterparty risk Yes (bank default risk) No (clearinghouse)
Liquidity Lower Higher
Flexibility High Low (standard contracts)

How hedging works (ACCA Technical Article):

Example:

• US exporter expects to receive €5m in 3 months

• Current exchange rate: $/€1.24
• Expect € to weaken to $/€1.10
• Futures price: 1.24
Hedge:

1. Sell €/$ futures now at 1.24

2. In 3 months, € weakens, futures price falls to 1.10
3. Buy back futures at 1.10
4. Profit on futures: (1.24 - 1.10) × contract size × number of contracts
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Result: Profit on futures offsets loss on main transaction (€ receipt now worth fewer $).

Basis risk: Futures price may not move perfectly in line with spot rate → Imperfect hedge.

Note: FM syllabus does NOT require numerical calculations for currency futures – understanding
concept only.

7.4 Currency Options

Definition: Right (but not obligation) to buy or sell currency at fixed rate (exercise price) on or
before specified date.

Types:

• Call option: Right to buy currency

• Put option: Right to sell currency (think: "put" up for sale)
Key features:

• Not binding (can let option lapse if favorable to do so)

• Premium paid upfront (non-refundable)
• Expensive (cost of flexibility)
When to use:

• Uncertain cash flows (e.g., tender bid – don't know if you'll win)
• Want to benefit from favorable rate movements while protecting downside
Illustration 7: Currency Option

Scenario from ACCA Technical Article:

• UK exporter expecting to receive $1m in 90 days

• Current spot rate: $/£1.40
• Concerned if £ strengthens beyond $/£1.50
• Action: Buy £ call option at exercise price $/£1.50
Outcome 1: £ strengthens to $/£1.60

• Exercise option: Buy £ at 1.50

• Receive: $1m ÷ 1.50 = £666,667 (protected!)
• Without option: Would have received only £625,000 ($1m ÷ 1.60)
Outcome 2: £ weakens to $/£1.20

• Let option lapse (don't exercise)

• Convert at spot: $1m ÷ 1.20 = £833,333 (benefit from favorable movement!)
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Cost: Upfront premium (say £10,000 – non-refundable)

Advantage: "Too good to be true?" – Protection + potential gain. BUT you pay premium.

Analogy (ACCA Technical Article): Options are like house insurance:

• If house doesn't burn down, don't claim, but don't get premium back
• If disaster, insurance prevents massive loss
• Premium is cost of protection
Advantages:

• Downside protection
• Upside potential
• Flexibility (can let lapse)
• Useful for uncertain cash flows
Disadvantages:

• Expensive (upfront premium)

• Premium lost if option not exercised
Note: FM syllabus does NOT require numerical calculations for currency options – understanding
concept and when to use only.

8. HEDGING STRATEGY SELECTION

Key decision factors:

8.1 Certainty of Cash Flow

Cash Flow Certainty Best Hedge

Certain (definite transaction) Forward contract or money market hedge
Uncertain (e.g., tender bid, possible sale) Currency option

8.2 Risk Appetite

Risk Appetite Approach

Risk-averse Hedge fully (forward, money market, option)

Risk-tolerant Partial hedge or no hedge (accept exposure)

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8.3 View on Future Rates

Expectation Action
Expect favorable movement Option (protect downside, keep upside) or no hedge
Expect adverse movement Forward or money market (lock in now)
Uncertain Forward or money market (certainty)

8.4 Cost Considerations

Cheapest to Most Expensive

1. Internal methods (invoice in home currency, netting, matching) – zero external cost
2. Forward contract – no upfront cost
3. Money market hedge – interest costs
4. Currency option – expensive premium

8.5 Flexibility Requirements

Need Best Choice

Need flexibility (uncertain transaction) Option
Want certainty (definite transaction) Forward or money market

Examiner tip: Always justify your hedge choice with reference to scenario specifics (cash flow
certainty, cost, company risk policy).

9.3 Key Formulas

Purchasing Power Parity:
1 + ℎ𝑐
𝑆1 = 𝑆0 ×
1 + ℎ𝑏

Interest Rate Parity:

1 + 𝑖𝑐
𝐹0 = 𝑆0 ×
1 + 𝑖𝑏
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Money market hedge (receiving foreign currency):

Future receipt
Borrow amount =
days
1 + (𝑟 × )
365
Money market hedge (paying foreign currency):
Future payment
Deposit amount =
days
1 + (𝑟 × )
365

INTEREST RATE RISK

1. INTRODUCTION TO INTEREST RATE RISK

Definition: Risk that changes in interest rates will adversely affect a company's cash flows,
profitability, or value.

Why it matters:

• Affects cost of borrowing (loans, bonds)

• Affects return on deposits and investments
• Impacts project appraisal (discount rates)
• Can significantly affect profitability
Who faces interest rate risk?

• Companies with variable rate debt (exposure to rate rises)

• Companies with variable rate deposits (exposure to rate falls)
• Companies planning future borrowing or deposits

2. TYPES OF INTEREST RATE RISK

2.1 Gap Exposure (Maturity Mismatch)

Definition: Mismatch between interest rate-sensitive assets and liabilities.

Example:
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Amount ($m) Interest Rate Type

Assets (Deposits) 50 Variable rate
Liabilities (Loans) 80 Variable rate
Net position (30)

Table 3: Gap exposure example

Gap: (30)𝑚 – company is a net borrower on variable rates

If interest rates rise by 1%:

• Interest income increases: $50m × 1% = $0.5m ✓

• Interest expense increases: $80m × 1% = $0.8m ✗
• Net effect: Loss of $0.3m p.a.
Who is exposed?

Position Exposure
Net borrower (liabilities > assets) Exposed to rate rises
Net depositor (assets > liabilities) Exposed to rate falls

Most relevant to: Banks and financial institutions (large asset/liability portfolios).

2.2 Basis Risk

Definition (Type 1): Risk that different variable rates do not move in perfect correlation.

Example:

• Company has variable rate deposits linked to 1-month LIBOR

• Company has variable rate borrowings linked to 12-month LIBOR
• These rates may not move perfectly together
• Result: Interest income and expense don't offset exactly
Definition (Type 2 – Futures hedging): Risk that futures price doesn't move perfectly with the
underlying interest rate exposure.

Example:

• Company hedges 3-month loan with 3-month interest rate futures

• Actual loan rate and futures price may not move in perfect correlation
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• Result: Imperfect hedge (some residual risk remains)

Key insight (ACCA Technical Article): Basis risk exists when changes in interest rates are not
exactly correlated with changes in futures prices.

3. CAUSES OF INTEREST RATE FLUCTUATIONS

Understanding drivers helps predict future rates and inform hedging decisions.

3.1 Central Bank Policy

Mechanism: Central banks set base rates to achieve macroeconomic objectives (control inflation,
stimulate growth).

Effects:

• Rate rise → Reduce inflation, slow growth (contractionary policy)

• Rate cut → Stimulate growth, increase inflation (expansionary policy)

3.2 Inflation Expectations

Relationship: Higher expected inflation → Higher interest rates

Why? Lenders demand compensation for inflation erosion of real value.

Fisher Effect:

(1 + 𝑖) = (1 + 𝑟)(1 + ℎ)

Where:

• 𝑖 = Nominal interest rate

• 𝑟 = Real interest rate
• ℎ = Inflation rate
Approximation: 𝑖 ≈ 𝑟 + ℎ

Example:

• Real rate: 2%
• Expected inflation: 3%
• Nominal rate: ≈ 2% + 3% = 5%

3.3 Economic Growth

Strong growth → Higher rates (central bank raises rates to prevent overheating)
Recession → Lower rates (central bank cuts rates to stimulate)
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3.4 Government Borrowing

High government borrowing → Increased demand for funds → Rates rise
(Crowding out effect)

3.5 Supply and Demand for Credit

High demand for loans → Rates rise
Low demand → Rates fall

4. YIELD CURVES AND TERM STRUCTURE

4.1 The Yield Curve

Definition: Graph showing relationship between interest rate (yield) and maturity for similar quality
bonds.

Types of yield curves:

Yield Curve Shapes

1. Normal (Upward Sloping):

• Long-term rates higher than short-term rates

• Most common shape
• Reflects:
o Liquidity preference (investors want premium for tying up money longer)
o Expected rate rises
o Inflation risk premium
2. Inverted (Downward Sloping):

• Short-term rates higher than long-term rates

• Rare – often signals recession ahead
• Reflects:
o Expected rate falls
o Central bank fighting inflation (high short-term rates)
3. Flat:

• Similar rates across all maturities

• Reflects uncertainty or transition period
4. Humped:
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• Medium-term rates highest

• Reflects specific market expectations

4.2 Theories of Yield Curve Shape

A. Expectations Theory

Proposition: Long-term rates are geometric average of current and expected future short-term rates.

Implication:

• Upward sloping → Market expects rates to rise

• Downward sloping → Market expects rates to fall
• Forward rates = Market's prediction of future spot rates
Example:

• Current 1-year rate: 2%

• Expected 1-year rate in 1 year: 4%
• 2-year rate today: √(1.02)(1.04) − 1 ≈ 3%
B. Liquidity Preference Theory

Proposition: Investors prefer liquidity (short-term) → Require premium to invest long-term.

Implication:

• Long-term rates include liquidity premium

• Normal (upward sloping) curve is natural state
• Even if rates expected to be stable, long-term rates higher
Why?

• Long-term bonds tie up funds

• Higher price volatility risk
• Less liquid (harder to sell)
C. Market Segmentation Theory

Proposition: Different investors operate in different maturity segments → supply/demand in each

segment determines rates independently.

Implication:

• Yield curve shape determined by supply/demand in each segment

• Not necessarily related to expectations
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• Different investor preferences:

o Pension funds prefer long-term (match liabilities)
o Banks prefer short-term (match deposit maturities)
Key insight: All three theories have some validity – real-world yield curves influenced by all three
factors.

4.3 Using Yield Curve for Decision-Making (Examiner Report)

Scenario: Company needs to borrow. Yield curve is inverted (short-term rates higher than long-
term).

Question: What are the implications for financing strategy?

Answer framework:

Inverted yield curve implications:

1. Long-term borrowing attractive (rates currently lower than short-term)

2. Market expects rates to fall (expectations theory)
3. If borrow short-term now, may face even lower rates when refinancing
4. Trade-off: Certainty (lock in long-term) vs. potential savings (borrow short, refinance later
when rates fall)
Recommendation:

• Risk-averse company → Borrow long-term now (lock in low long-term rates)

• Risk-tolerant company → Borrow short-term, refinance later if rates fall as expected
Examiner feedback: Many candidates struggle to explain why inverted curve affects decisions.
Must link yield curve shape to expectations and strategic implications.

5. INTERNAL (TRADITIONAL) METHODS OF MANAGING INTEREST RATE RISK

5.1 Matching
Definition: Match interest rate characteristics of assets and liabilities.

Example:

• Company has variable rate loan

• Invests surplus cash in variable rate deposit
• Result: If rates rise:
o Loan interest expense ↑
o Deposit interest income ↑
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o Net effect offset

Benefit: Reduces gap exposure (Type 1 basis risk may remain if rates linked to different
benchmarks).

Limitation: Requires suitable assets to match liabilities (or vice versa).

5.2 Smoothing
Definition (ACCA Technical Article): Divide borrowings (or deposits) between fixed and variable
rates.

Example:

• Total borrowing: $10m

• $5m at fixed rate (e.g., 5% p.a.)
• $5m at variable rate (currently 4% p.a.)
If rates rise to 6%:

• Fixed rate borrowing: Still costs 5% (unaffected)

• Variable rate borrowing: Now costs 6%
• Average cost: (5% + 6%) ÷ 2 = 5.5%
• Impact reduced (only half exposed to rise)
If rates fall to 3%:

• Fixed: Still 5%
• Variable: Now 3%
• Average: (5% + 3%) ÷ 2 = 4%
• Company benefits partially from fall
Benefit (ACCA Technical Article): "If interest rates rise, only the variable rate loans will cost more
and this will have less impact than if all borrowings had been at variable rate."

Limitation: Partial exposure remains – doesn't eliminate risk entirely.

5.3 Asset and Liability Management

Definition: Actively manage timing and structure of assets/liabilities to reduce interest rate
exposure.

Strategies:

• Match maturities: Align timing of asset and liability rate resets

• Restructure debt: Refinance variable rate debt with fixed rate (or vice versa)
• Adjust deposit terms: Change deposit periods to match loan periods
 RISK MANAGEMENT

Example:

• Company has 3-year variable rate loan

• Refinance to 3-year fixed rate loan
• Eliminates interest rate risk on that borrowing
Benefit: Flexibility to restructure based on rate expectations.

Limitation: May involve costs (refinancing fees, break costs on fixed rate loans).

6. FORWARD RATE AGREEMENTS (FRAs)

6.1 What is an FRA?

Definition: OTC contract that fixes the interest rate on a future loan or deposit for a specified
period.

Key features:

• No upfront cost
• Customizable (amount, dates, rate)
• OTC (arranged with bank)
• Cash settled (no actual borrowing/lending – just compensating payment)
• Fixes interest rate (certainty achieved)
FRA Notation: "X v Y" or "X x Y"

• X = Months until loan/deposit starts

• Y = Months until loan/deposit ends
• Duration of underlying = Y - X months
Examples:

• "3 v 9" FRA: Loan starts in 3 months, ends in 9 months → 6-month loan (9 - 3)
• "2 v 5" FRA: Loan starts in 2 months, ends in 5 months → 3-month loan (5 - 2)

6.2 How FRAs Work

Illustration 8: FRA Hedge

Scenario (from ACCA Technical Article):

• Company (Nero Co) will borrow $2m in 4 months for 3 months (repay in month 7)
• Current 3-month rate: 5%
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• Worried rates will rise

• Action: Buy "4 v 7" FRA at 5%
Outcome 1: Rates rise to 6.5%

Actual borrowing:

• Borrow $2m at market rate 6.5%

3
• Interest for 3 months: 2𝑚 × 6.5% × 12 = $32,500
FRA settlement:
3
• Bank compensates for difference: (6.5% − 5%) × $2𝑚 × 12 = $7,500

• Nero receives $7,500 from bank

Net interest cost: $32,500 − $7,500 = $25,000
3
Effective rate: $25,000 ÷ ($2𝑚 × 12) = 𝟓\% ✓

Outcome 2: Rates fall to 3%

Actual borrowing:

• Borrow $2m at market rate 3%

3
• Interest: 2𝑚 × 3% × 12 = $15,000
FRA settlement:
3
• Nero pays bank the difference: (5% − 3%) × $2𝑚 × 12 = $10,000
Net interest cost: $15,000 + $10,000 = $25,000
Effective rate: 𝟓\% ✓

Key insight (ACCA Technical Article): "Interest rate locked in at 5%, regardless of market
movements."

Note (ACCA Technical Article): "In part (iii) when interest rates have fallen, Nero Co would no
doubt wish that it had not entered the FRA so that it would not have to pay [the bank]. [But
certainty was the goal.]"

6.3 FRA Advantages and Disadvantages

Advantages:

• No upfront premium
• Fixes interest rate (certainty)
• Customizable (amount, dates, rate)
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• Separate from actual borrowing (FRA with Bank A, loan from Bank B)
Disadvantages:

• Binding obligation (can't benefit from favorable rate movements)

• OTC (counterparty credit risk – bank might default)
• Cash settled only (no actual lending/borrowing – need separate loan arrangement)
When to use:

• Definite future borrowing/deposit

• Want certainty (risk-averse)
• Zero upfront cost important

7. INTEREST RATE FUTURES

7.1 What are Interest Rate Futures?

Definition: Exchange-traded standardized contracts based on future interest rates.

Key features:

• Exchange-traded (not OTC)

• Standardized (contract sizes, maturity dates)
• Clearinghouse guarantee (no counterparty risk)
• Marked to market daily
• Highly liquid
How futures are quoted:

Futures price = 100 − Implied interest rate

Example:

• 3-month interest rate expected to be 3%

• Futures price = 100 − 3 = 𝟗𝟕. 𝟎𝟎
Key relationship:

• Interest rate rises → Futures price falls

• Interest rate falls → Futures price rises

7.2 Hedging with Interest Rate Futures

Hedging principle:
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Exposure Hedge Action

Expect to borrow (exposed to rate rises) Sell futures
Expect to deposit (exposed to rate falls) Buy futures

Why?

Borrower (worried about rate rise):

• Rates rise → Futures price falls

• Sold futures at high price, buy back at low price
• Profit on futures offsets higher borrowing cost
Depositor (worried about rate fall):

• Rates fall → Futures price rises

• Bought futures at low price, sell at high price
• Profit on futures offsets lower deposit return
Illustration 9: Interest Rate Futures Hedge

Scenario:

• Company will borrow $5m in 3 months for 3 months

• Current 3-month rate: 3%
• Futures price: 97.00
• Company worried rates will rise to 4%
Hedge: Sell 5 interest rate futures contracts at 97.00

Outcome (rates rise to 4%):

• Futures price falls to: 100 − 4 = 𝟗𝟔. 𝟎𝟎

• Buy back futures at 96.00
• Profit per contract: 97.00 − 96.00 = 1.00 point
Calculating profit:

• Each 0.01 movement (1 basis point) = $25 per contract

• Movement: 1.00 point = 100 basis points
• Profit per contract: 100 × $25 = $2,500
• Total profit (5 contracts): 5 × $2,500 = $12,500
Borrowing cost:
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3
• Extra interest from rate rise: 5𝑚 × 1% × 12 = $12,500

• Offset by futures profit ✓

Note: Calculations simplified for illustration. Actual futures hedging involves basis risk and tick
value calculations (not required in FM syllabus in detail).

7.3 Futures vs. FRAs

Feature FRA Interest Rate Futures

Market OTC Exchange-traded
Customization Fully customizable Standardized contracts
Counterparty risk Yes (bank) No (clearinghouse)
Liquidity Lower Higher
Basis risk Low Higher (standardized contracts may not match exactly)
Cost Zero upfront Margin requirements

Note: FM syllabus does NOT require detailed numerical questions on futures – conceptual
understanding only.

8. INTEREST RATE DERIVATIVES (ADVANCED)

8.1 Interest Rate Swaps

Definition: Agreement to exchange interest payment obligations (typically fixed for floating).

Structure:

• Notional principal (not exchanged – only interest payments)

• Party A pays fixed rate to Party B
• Party B pays floating rate (e.g., LIBOR + margin) to Party A
• Payments netted (only difference paid)
Example:

• Notional principal: $10m

• Party A pays 5% fixed
• Party B pays LIBOR + 1%
• Quarterly settlements
Period 1 (LIBOR = 4%):
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3
• Party A owes: 10𝑚 × 5% × 12 = $125,000
3
• Party B owes: 10𝑚 × 5% × 12 = $125,000

• Net: Zero (rates equal)

Period 2 (LIBOR = 3%):

• Party A owes: $125,000 (fixed 5%)

3
• Party B owes: 10𝑚 × 4% × 12 = $100,000

• Net: Party A pays Party B $25,000

Uses:

• Convert variable rate debt to fixed (or vice versa)

• Hedge interest rate exposure
• Exploit comparative advantage (one party can borrow fixed cheaper, other can borrow
floating cheaper)
Advantages:

• Flexibility (change interest profile without refinancing)

• No need to rearrange actual borrowing
• Long-term (swaps can be many years)
Disadvantages:

• Counterparty risk (OTC contract)

• Basis risk (if floating payment and actual loan linked to different rates)
Note: FM syllabus does NOT require numerical calculations for swaps – understanding concept and
uses only.

8.2 Interest Rate Options (Caps, Floors, Collars)

Interest Rate Cap:

• Right (not obligation) to cap interest rate at maximum level

• Pay premium upfront
• If rates exceed cap, receive compensating payment
Interest Rate Floor:

• Right to ensure minimum interest rate received

• Pay premium
 RISK MANAGEMENT

• If rates fall below floor, receive compensating payment

Interest Rate Collar:

• Combination: Buy cap, sell floor

• Reduces premium cost (floor premium offsets cap premium)
• Protects against rate rises beyond cap, but gives up gains if rates fall below floor
When to use:

• Cap: Borrower wants protection against rate rises but wants to benefit if rates fall
• Floor: Depositor wants protection against rate falls
• Collar: Borrower wants cheaper protection (lower premium than cap alone)
Note: FM syllabus does NOT require numerical calculations – understanding only.

9. HEDGING STRATEGY SELECTION (INTEREST RATE RISK)

Key decision factors:

9.1 Certainty of Exposure

Exposure Certainty Best Hedge

Certain borrowing/deposit FRA, futures, swap
Uncertain Interest rate option (cap/floor)

9.2 Risk Appetite

Risk Appetite Approach

Risk-averse Fix rate now (FRA, swap to fixed)
Risk-tolerant Stay on variable rates, use partial hedge

9.3 View on Future Rates

Expectation Borrower Action Depositor Action

Rates will rise Hedge now (FRA, sell futures, swap to
Benefit (no hedge or buy cap for upside)
fixed)
Rates will fall Benefit (no hedge or buy cap for protection)
Hedge now (FRA, buy futures, stay fixed)
Uncertain Hedge (FRA, futures, swap) Hedge
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9.4 Cost Considerations

Cheapest to Most Expensive

1. Internal methods (matching, smoothing) – zero cost
2. FRA – no upfront cost
3. Futures – margin costs
4. Swaps – arrangement fees
5. Options (caps, floors) – expensive premium

9.5 Flexibility Requirements

Need Best Choice

Want certainty FRA or swap to fixed
Want flexibility (benefit from favorable moves) Interest rate option (cap)
Want long-term hedge Interest rate swap

Examiner tip (ACCA Technical Article): "Treasury function guidelines emphasise the importance
of mitigating the impact of adverse movements in interest rates. However, they also allow staff to
take into consideration upside risks associated with interest rate exposure when deciding which
instrument to use."

KEY FORMULAS SUMMARY

Foreign Exchange:

Purchasing Power Parity:

1 + ℎ𝑐
𝑆1 = 𝑆0 ×
1 + ℎ𝑏

Interest Rate Parity:

1 + 𝑖𝑐
𝐹0 = 𝑆0 ×
1 + 𝑖𝑏

Money market hedge (receiving foreign currency):

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Future receipt
Borrow = 𝑡
1 + (𝑟 × )
365
Money market hedge (paying foreign currency):
Future payment
Deposit = 𝑡
1 + (𝑟 × )
365
Interest Rate:

Fisher Effect:

(1 + 𝑖) = (1 + 𝑟)(1 + ℎ)

or 𝑖 ≈ 𝑟 + ℎ

Futures price:

Futures price = 100 − Implied interest rate

FRA effective rate: Should equal agreed FRA rate after compensation