Association for Financial Professionals (AFP) Practice Exam

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A company that invests in floating rate assets but borrows long-term at fixed rates can benefit from which derivative?

  1. Currency futures

  2. Interest rate caps

  3. Interest rate swaps

  4. Currency swaps

The correct answer is: Interest rate swaps

A company that invests in floating rate assets while borrowing long-term at fixed rates is exposed to interest rate risk. In this scenario, the company is likely to benefit from using interest rate swaps. Interest rate swaps are financial derivatives that allow two parties to exchange cash flows based on different interest rates. In this case, the company can enter into a swap agreement where it pays a floating interest rate and receives a fixed interest rate. This alignment acts as a hedge against the interest rate exposure since the company is already earning on floating rate assets. By receiving a fixed rate from the swap, the company protects itself from potential increases in interest rates that could raise its borrowing costs. This strategy stabilizes its cash flows and reduces the risk associated with fluctuating interest rates. In contrast, currency futures, interest rate caps, and currency swaps do not provide the same direct benefit in this context since they either deal with currency fluctuations or offer limited protection against rising interest rates rather than the specific combination of fixed and floating rates affecting the company's financial position.