What Correlation Methods Are Available to Price a CMS Spread Option & CMS Spread Swap

The pricing of a CMS spread option and a CMS spread swap is dependent on correlations between the two referenced indexes.

You can choose between two correlation methods:

Term structure correlation

This correlation method defines that you want to use a defined term structure for the correlation. The data is shown in the Correlation Curve window (which is accessed by clicking the Correlation Term Structure button). The correlation term structure is calibrated to use real interbank trading prices. Each point shows the correlation that a single caplet/floorlet with that expiration would trade at in the market. These prices are the best reflection of the true mid-market that is possible because this is where large dealers transfer risk with each other in the broker market. The values in the term structure can also be edited.

See Working With the Correlation Curve Window for more information on the Correlation Curve window.

This is the default correlation method used by the system to price a CMS spread swap or CMS spread option.

Flat correlation

This correlation method defines that you want to use a single, constant correlation value. Due to lack of liquidity in this market, the term structure correlation is not always an accurate indicator of future movement. Selecting Flat Correlation lets you specify one correlation value to be used at every point.

You select the method of correlation via the Use Correlation field in the pricing page. If you choose to use the flat correlation method, an empty field is then displayed in which you enter the flat correlation amount.