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Which of the following statements about interest rate risk hedging is correct?
A. An interest rate floor can be used to hedge an expected increase in interest rates
B. The cost of an interest rate floor is higher than the cost of an interest rate collar
C. The premium on interest rate option is payable when it is exercised
D. The standardised nature of interest rate futures means that over- and under- hedging can be avoidedAnswer given by BPP is B but I think should be D. Could you please explain why the interest rate floor is higher than the cost of an interest rate collar? And why option D is incorrect?
D is wrong because (as you will know if you have watched my free lectures) when you use futures it has to be in fixed size contracts. So it is unlikely you can hedge the exact amount needed – it will either be a bit too much or a bit too little.
With regard to the interest rate collar – this is really more of a Paper P4 idea and BPP should not really have included it for Paper F9. It costs money to get an interest rate floor (you pay a premium for the option). To also have an interest rate cap (an upper limit on interest rates) as well – which is what a collar is – you sell an option to someone else who wants that limit. They way you a premium for the option which means that the net cost (paying for one option and receiving money for the other) is lower.
I would not worry too much about the collar for Paper F9 – again it is more of a Paper P4 topic.
If (as is very unlikely) this were to be asked, then you should be clear as to why A and C and (hopefully now D) are not correct, and therefore the right answer has to be B 🙂6 years on… This is now Q13 in ACCA FM Practice Exam 2. Thanks for the explanation, very helpful.
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