Constant maturity swap

A constant maturity swap, also known as a CMS, is a swap that allows the purchaser to fix the duration of received flows on a swap.

The floating leg of an interest rate swap typically resets against a published index. The floating leg of a constant maturity swap fixes against a point on the swap curve on a periodic basis.

A constant maturity swap is an interest rate swap where the interest rate on one leg is reset periodically, but with reference to a market swap rate rather than LIBOR. The other leg of the swap is generally LIBOR, but may be a fixed rate or potentially another constant maturity rate. Constant maturity swaps can either be single currency or cross currency swaps. Therefore, the prime factor for a constant maturity swap is the shape of the forward implied yield curves. A single currency constant maturity swap versus LIBOR is similar to a series of differential interest rate fix (or "DIRF") in the same way that an interest rate swap is similar to a series of forward rate agreements. Valuation of constant maturity swaps depends on volatilities and correlations of different forward rates and therefore requires an interest rate model or some approximated methodology like a convexity adjustment, see for example Brigo and Mercurio (2001).

Example

A customer believes that the difference between the six-month LIBOR rate will fall relative to the three-year swap rate for a given currency. To take advantage of this, he buys a constant maturity swap paying the six-month LIBOR rate and receiving the three-year swap rate.

References

• Damiano Brigo and Fabio Mercurio (2001). Interest-Rate Models: Theory and Practice - with Smile, Inflation and Credit, Springer Verlag, 2nd ed. 2006.

External links

• Interest Rate Exotics: The Gamma Trap Risk Magazine (2006), Navroz Patel