Financial Risk Manager Part 1

Explanation

Correct Answer: B - Options on interest rate futures

Interest rate futures are derivative contracts where the holder agrees to buy or sell an interest-bearing asset on a future date. The price of an interest rate future moves inversely to changes in interest rates:

• When interest rates decrease → price of interest rate future increases
• When interest rates increase → price of interest rate future decreases

An option on an interest rate future gives the holder the right (but not obligation) to buy (call option) or sell (put option) the underlying interest rate future at a specified strike price before expiration.

Why this works as a hedge:

• A put option on interest rate futures would be effective for this firm
• If interest rates rise: firm can exercise the put option to sell the interest rate future at the strike price (which would be higher than the market price)
• This gain offsets the increased borrowing costs from rising interest rates
• If interest rates fall: firm can let the option expire and benefit from lower borrowing costs

Why other options are incorrect:

A. Currency forward contracts - Used to hedge against exchange rate fluctuations, not interest rate changes

C. Currency swaps - Involve exchanging one currency for another to manage foreign exchange risk, not interest rate risk

D. Currency futures contracts - Similar to currency forwards, primarily used for hedging foreign exchange risk, not protection against rising interest rates