The correct answer is A, that statements 1 and 2 only are correct. Many candidates chose answers B or D rather than answer A.

This question considered three ways to hedge interest rate risk. Interest rate options can be used to hedge an adverse interest rate movement, while allowing the buyer to let the option lapse in order to benefit from favourable interest rate movements. The first statement was therefore correct.

A forward rate agreement will lock a borrower into a specified interest rate for a specified period on a specified notional amount of money, from a specified future date.

Depending on the actual interest rate on the specified future date, compensating payments are made either by the borrower to the bank (if the actual interest rate is favourable to the borrower), or by the bank to the borrower (if the interest rate is unfavourable to the borrower).

The borrower cannot therefore benefit from a decrease in interest rates and so the second statement is correct.

With interest rate futures, a borrower hedges against an interest rate increase by selling futures now and buying futures on a future date, while a lender hedges against an interest rate decrease by buying futures now and selling them on a future date. The third statement is therefore incorrect.