A CMS swap (also known as a constant maturity swap) is an interest rate swap where at least one of the legs is based on a floating rate set by reference to a long-term capital market rate (i.e., a swap rate) rather than by reference to a short-term cash rate such as LIBOR or EURIBOR.
The other leg can pay a fixed rate, a floating rate referenced to a short term cash rate (e.g., Libor) or a floating rate referenced to another CMS rate.
CMS swaps let an investor take a view on the relationship between a chosen short term interest rate and a chosen long term interest rate. If the investor thinks that the yield curve will:
Steepen, then the investor will choose to receive the long term interest rate.
Flatten, then the investor will choose to receive the short term interest rate.
From a hedger’s perspective, a floating rate borrower who implements the annual budgeting according to a long term swap rate (for example, 10y rates) can enter into a CMS payer swap whereby he will be paying the 10y CMS rate minus a spread and receiving a short term cash rate.
The two interest rates are unlikely to be equal. For example, when the yield curve slopes upward, the long term interest rate will be higher than the short term one. As a result, when you calculate the instrument the system determines the fixed percentage (or spread) that must be added to the short term interest rate in order to ensure that the deal is zero-cost at the outset.
Advantages of a CMS Swap
The advantages of a CMS swap are that:
There is no premium.
You can set a floating rate to a longer tenor than is available in the short-term published indexes.
It is a flexible method of hedging or speculating against the movements in the slope of the yield curve.
Pricing a CMS Swap In SDX Interest Rates
When pricing a CMS swap in SDX Interest Rates, if the second leg is a floating leg and you:
Do not define a spread for either leg, the system calculates the spread of the floating leg that will give the instrument a zero NPV.
Enter a spread for the CMS leg, the system calculates the spread for the floating leg to give the instrument a zero NPV. If you then edit the spread of the floating leg, the instrument’s NPV is no longer zero.