A CMS spread swap is an interest rate swap where the coupon of the CMS leg is set on each fixing as the difference between two distinct long term swap rates.
The general formula for the coupon paid by the CMS leg is calculated as follows:
Min(Max Coupon, Max(Min Coupon, (Fixed + Gearing1*Index1 - Gearing2*Index2)))
This payout is then accrued for the chosen day count basis.
In other words, the coupon paid by the CMS payer is calculated as Fixed + Gearing1*Index1 - Gearing2*Index2, but can never be larger than the specified maximum coupon or lower than the specified minimum coupon.
Advantages of a CMS Spread Swap
A CMS spread swap lets an investor express a view on the spread between two swap rates, such as the 10 year and 2 year swap rates. Therefore it enables an investor to benefit from the flattening or steepening of the yield curve.
Pricing a CMS Spread Swap
When pricing a CMS spread swap you need to be aware of the following:
By default the minimum coupon payout is set to zero (which means the payout cannot be a negative amount) and the maximum coupon is not specified. Changing these fields allows for a more precise payoff and consequently a different risk/reward profile.
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.