A CMS spread option is similar to a cap/floor (as described in Cap and Floor). The difference is that whereas in a cap/floor the underlying is usually a reference cash rate, in a CMS spread option the underlying is the spread between the yields of two different long term swap rates.
When pricing a CMS spread option the user can choose either of the following:
CMS spread cap/floor
A CMS spread option usually consists of a series of options which are also known as caplets/floorlets. Each caplet/floorlet provides the buyer protection for a single payment period. A cap protects against an increase in the swap rate spread, whereas a floor protects against an inversion or reduction in the swap rate spread. On each fixing date, if the underlying is above the strike (for a cap) or below the strike (for a floor) the buyer receives a payout. The payout formula for the:
Cap version of a CMS spread option is as follows:
Max((Gearing1*Index1 - Gearing2*Index2) - Strike, 0)
Floor version of a CMS spread option is as follows:
Max(Strike - (Gearing1*Index1 - Gearing2*Index2), 0)
CMS spread straddle
A straddle CMS spread option is a liquidity trade. As such it is useful for dealers who want to buy/sell correlation risk.
The general formula for a payout of a straddle is
Abs((Gearing1*Index1 - Gearing2*Index2) - Strike)
Usually the underlying rates are set in advance, i.e., they are set at the start of each payment period and paid at the end of that payment period1. However, they can also be set in arrears (i.e., at the end of the payment period, on the same date the payment itself is made).
There is also a third type of option, which has become quite popular in the market in recent years called the “one-look” (or “single-look”) option. For more information see the Single Look CMS Spread .
You can also choose to add a condition to a CMS spread option.
A CMS spread option is an efficient way to exercise a view on the shape of the yield curve. In environments where the yield curve is very flat, the forecasted spread is low. However, from historical analysis, in stable economic environments yield curves tend to be characterized by low short term rates relative to longer term rates. In recent years for example, the 10 years – 2 year spread in USD has been as high as 200bp. Therefore, in markets where yield curves are currently flat, an investor could purchase a CMS spread cap based on a 10 year – 2 year spread for a relatively low price. Subsequently, if over the tenor of the option the curve normalizes, the investor will be in-the-money and will generate a significant gain.
Typically banks use CMS spread options to hedge the CMS spread options that they have entered into with customers.
In addition, adding a condition to a CMS spread option makes the instrument cheaper. This is becoming a common way for hedge funds to cheapen a strategy on the shape of the yield curve.
An investor believes that the yield curve will steepen relative to that predicted by the current forward curve. The investor therefore buys a 5 year USD CMS spread option on a 10 year swap minus a 2 year swap with a strike of 1.25% and a notional of USD 100m. The investor will get paid at each fixing where the difference between the ten year and the two year swap rate is greater than 1.25%.
If on the first fixing the 10 year swap rate exceeds the 2 year swap rate by 2%, the investor has made a 0.75% gain at the fixing date. The payout is the <difference between strike and underlying> x <notional> x <fraction of year>, so it is as follows:
(2% - 1.25%) x $100,000,000 x (days/360)
Conversely, an investor who believes that the yield curve will flatten will buy a CMS spread floor rather than a CMS spread cap.
Pricing a CMS Spread Option in SDX Interest Rates
When pricing a CMS spread option you need to be aware of the following:
When you define which swap rates to use, you can define what percentage of each swap rate is to be used in the payout calculation. You do this by specifying a Gearing value for each swap rate.
You must define which correlation method to use to price the instrument. For more information see What Correlation Methods Are Available to Price a CMS Spread Option & CMS Spread Swap.
The correlation curve between the two underlying indexes (or data series) is taken into account.
You can see the index correlation data in the instrument’s Correlation Curve window (accessed by clicking the Correlation Term Structure button). For more information see Working With the Correlation Curve Window.
You can see the exposure of the instrument to a change in the correlation value in the Correlation Exposure result.
It is the frequency defined in the Roll Schedule area that sets the instrument’s fixing and payment frequency. The frequency and day count basis dropdown lists next to each index simply let you determine which conventions are used by the index itself. Changing the frequency of the index and the day count basis will affect the rate slightly.
The condition states that the selected index, which can be based on either of the instrument's underlying indexes, i.e., Index 1 or Index 2, must be above or below a predefined rate. The same condition is applied to all underlying caplets/floorlets. By default no condition is set.