A CMS cap is similar to a Cap in that it protects its buyer from a rise in a floating interest rate above the level (i.e., the strike) specified in the contract. The difference is that the floating interest rate is linked to a long-term swap rate rather than to a short term cash rate.
So for example, a CMS cap will allow a corporate borrower with liabilities linked to a CMS rate to purchase protection against rising swap rates. Similar to any cap, the buyer of the CMS cap will receive payments only for the periods where the relevant interest rate index is fixed above the strike.
In return for the protection it provides, the buyer of the CMS cap pays a premium to the seller. Expressed as a percentage of the notional, the premium is usually paid upfront.
Pricing a CMS Cap in SDX Interest Rates
Pricing a CMS cap in SDX Interest Rates is the same as pricing a cap (see Pricing a Cap in SDX Interest Rates) with the following exceptions:
At least one leg pays a floating rate based on a long-term rate.
Currently the premium can only be paid upfront.