The correct answer is B.

Interest rate futures are a type of derivative contract through which 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 the change in interest rates. If interest rates go down, the price of the interest rate future goes up and vice-versa. An option on an interest rate future gives the holder the right, but not the obligation, to buy (call option) or sell (put option) the underlying interest rate future at a specified price (the strike price) on or before a specified date (the expiration date).

In this case, a put option on an interest rate future would be an effective hedge for the firm. If interest rates rise, the firm can exercise its option to sell the interest rate future at the strike price, which would be higher than the market price. This would offset the increased cost of borrowing due to the rise in interest rates. If interest rates fall, the firm can choose not to exercise its option and benefit from the lower borrowing cost.

Choice A is incorrect. Currency forward contracts are used to hedge against the risk of exchange rate fluctuations, not interest rate changes. They allow parties to buy or sell a specific amount of foreign currency at a predetermined price on a future date, thus providing no protection against rising interest rates.

Choice C is incorrect. Currency swaps involve the exchange of one currency for another between two parties, with an agreement to reverse the swap at a later date. While this can help manage exposure to foreign exchange risk, it does not directly address the risk of rising interest rates on a loan.

Choice D is incorrect. Similar to currency forward contracts, currency futures contracts are used primarily for hedging against foreign exchange risk and do not provide protection against increasing market interest rates.

Things to Remember

• Options on interest rate futures provide the right, but not the obligation, to enter into an interest rate futures contract at a specified price before the option expires.
• These options allow investors to speculate on the direction of interest rates with a known risk (the premium paid for the option), making them a critical tool for managing interest rate exposure.