Derivatives & Hedging – Interview Questions for Finance

A forward contract is a single, customized agreement (OTC) to exchange currencies or cash flows at a fixed rate on one specific future date. 

A swap is essentially a series of forwards: two parties agree to exchange cash flows on multiple dates over a period of time.

The key differences are:

• Timing: a forward is one transaction at maturity, a swap is ongoing.
• Purpose: forwards are usually used for short-term hedging, swaps for longer-term or recurring exposures.

In practice, a company with floating-rate debt (debt where the interest rate moves with a benchmark such as Euribor or SOFR, plus a spread) may use an interest rate swap to convert those variable payments into fixed ones. This reduces uncertainty and protects against rising interest rates without refinancing the original debt.

A pay-fixed, receive-floating interest rate swap is a contract where the company agrees to:

• Pay a fixed rate (here, 3%) on a notional amount, and
• Receive the floating rate (here, Euribor + 2%) on the same notional.

No actual principal is exchanged; only the net interest difference is settled.

In short: The Company pays floating (Euribor + 2%) to the Bank for its debt. At the same time, through the swap, it pays fixed 3% to the Counterparty and receives floating (Euribor + 2%) back. 

The floating outflow and inflow cancel each other, leaving the Company with only the fixed 3% payment. The effective annual interest expense is €3.0m, fixed at 3% on €100m.

In detail, you could do the calculation like this:

1. Identify cash flows: Before calculating, list all debt and swap cash flows separately so you can see what will offset what.

• Debt: Euribor 1% + 2% = 3% on €100m.
• Swap: pay fixed 3% on €100m, receive floating (3%) on €100m.

2. Calculate debt interest (without swap): Start with the debt alone, as that is the company’s baseline exposure.

3. Calculate swap legs: Break the swap into its two sides (fixed and floating) to make netting easier.

4. Net the position (debt + swap): Combine the debt and swap cash flows to see the effective interest cost.

The swap cancels out the floating component of the debt, leaving only the fixed leg. The effective annual interest expense is €3.0m.

In this swap, the company pays a fixed 3% and receives floating (Euribor + 2%).

In short: With Euribor at 4%, the debt costs 6%. The swap gives back that floating 6% and replaces it with a fixed 3%. The floating legs cancel, so the company still pays only the fixed 3% (€3.0m).

In detail, you could do the calculation like this: 

1. Calculate debt without swap: Start with the debt exposure to see what the company would pay unhedged.

2. Swap cash flows: Break down the swap into pay-fixed and receive-floating.

• Pay fixed: €100m × 3% = €3.0m outflow.
• Receive floating: €100m × 6% = €6.0m inflow.

3. Net position (debt + swap): Combine the debt outflow with the swap legs to find the effective cost.

The company pays floating 6% on the debt, but receives the same 6% back through the swap. What remains is only the fixed 3% payment.

The effective annual interest expense is €3.0m, fixed at 3% – exactly the same as before.

A company may choose an option instead of a forward because of the difference between obligation and flexibility.

• Forward contract: obligates the company to exchange at the agreed rate. This eliminates risk but also any upside if the market moves favorably.
• Option contract: gives the right, not the obligation to transact. This protects against adverse movements while still allowing the company to benefit if the market turns in its favor.

The trade-off is cost: options require paying a premium upfront, whereas forwards typically do not.

Example: A European importer needing USD could buy a call option. If the dollar strengthens, the option caps the cost. If the dollar weakens, the importer can let the option expire and buy at the cheaper spot rate.

A currency put option gives the right to sell USD at the strike rate. The company pays a premium upfront, regardless of whether it exercises the option.

1. Calculate premium cost: The company must pay the option premium regardless of whether the option is exercised. This cost reduces the final amount of euros received, so it should be subtracted after calculating the gross proceeds.

2. Case A with a Spot of 1.05: Since the spot rate (1.05) gives more euros per USD than the strike (1.08), the exporter does not exercise the option. Instead, the company converts its USD at the better spot rate.

3. Case B with a Spot of 1.12:  Since the spot rate (1.12) is less favorable than the strike (1.08), converting at spot would yield fewer euros. Therefore, the company exercises the option and sells USD at 1.08 to lock in the better rate.

The option guarantees a minimum of about €9.08m net if the USD weakens. If the USD strengthens, the exporter can benefit from the better spot rate, though the premium still reduces the proceeds.

While derivatives reduce certain risks, they also introduce new ones:

• Basis risk: the hedge may not perfectly match the underlying exposure (e.g. hedging with a different benchmark).
• Counterparty risk: in OTC contracts, the counterparty might default.
• Liquidity risk: unwinding or adjusting positions can be costly.
• Accounting complexity: hedge accounting rules can create earnings volatility.
• Opportunity cost: hedging removes upside potential if markets move favorably.

The company faces a mismatch: debt service is in USD while revenues are in EUR. This creates exposure to both currency risk (EUR/USD) and interest rate risk (US rates).

A suitable hedging strategy could include:

• FX forwards or swaps to lock in EUR/USD conversion for upcoming debt payments.
• FX options if the company wants protection but also the ability to benefit from favorable currency moves.
• Interest rate swaps to convert floating-rate USD debt into fixed payments, reducing uncertainty.
• Natural hedges where possible, for example by generating revenues or sourcing costs in USD.

Execution should align hedge maturities with debt service dates, with regular monitoring and adjustments if exposures change.

Several industries rely heavily on derivatives to stabilize cash flows.

• Airlines hedge jet fuel costs with oil derivatives to protect against volatile energy prices.
• Exporters and importers use currency forwards and options to manage FX risk on international sales or purchases.
• Utilities and infrastructure companies often use interest rate swaps to fix borrowing costs on long-term debt.

Derivatives are recorded at fair value on the balance sheet, usually under assets or liabilities depending on whether they are in or out of the money. Changes in value are reflected either in the income statement or in other comprehensive income (OCI) if hedge accounting applies.

• For fair value hedges, gains and losses flow through the income statement along with the hedged item.
• For cash flow hedges, gains and losses are first recognized in OCI and later reclassified to the income statement when the hedged transaction affects earnings.

Cash movements related to derivatives appear in the cash flow statement, typically under operating or financing activities, depending on the underlying exposure.