When would a treasurer use an interest-rate cap instead of a swap, and what's the cost trade-off?
A core Corporate Treasury interview question — asked in analyst and associate interviews across IB, PE, and the Big 4.
THE SHORT ANSWER
A pay-fixed swap converts floating debt to fixed at zero upfront premium but removes all benefit if rates fall and creates a mark-to-market/break cost. A cap is an option: the treasurer keeps floating-rate debt but buys protection so the effective rate can't exceed a strike — you pay an upfront premium, but you retain the downside benefit if rates fall and there's no negative MTM/break cost (the option just expires). So you'd choose a cap when you want protection against rate rises while keeping the upside of falling rates, when you may repay/refinance early (no break cost), or when you can't tolerate collateral/MTM volatility — accepting the premium as the price of that optionality. A swap suits a treasurer who wants certainty and is happy to forgo the downside, with no upfront cash. Collars (buy a cap, sell a floor) reduce or zero the premium by giving up some downside.
WHAT INTERVIEWERS LISTEN FOR
- ✓Swap: zero premium, no downside benefit, has MTM/break cost
- ✓Cap: pay premium, keep falling-rate benefit, no negative MTM
- ✓Cap suits possible early repayment / no MTM tolerance / wanting upside
- ✓Collar reduces premium by selling away some downside
COMMON MISTAKES
- ✗Thinking a cap and swap are equivalent
- ✗Ignoring the premium-vs-flexibility trade-off
- ✗Not knowing caps avoid break costs
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