FLASH SALE! - "FINANCIAL MODELING COURSE BUNDLE AT 60% OFF" Enroll Now

Constant Maturity Swap

Updated on January 3, 2024
Article byRutan Bhattacharyya
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What Is A Constant Maturity Swap (CMS)?

Constant maturity swaps (CMS) refer to derivatives whose payoffs are dependent upon the swap rate of a fixed or constant maturity. Such variations of interest rate swaps offer flexibility to institutions or investors trying to exploit or hedge the yield curve.

Constant Maturity Swap

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Constant Maturity Swap (wallstreetmojo.com)

Such swaps feature a floating and a fixed interest portion where the former portion is reset at fixed intervals against the rate of any fixed maturity instrument, which typically has a longer maturity period than the reset period’s duration. Because of this, investors remain vulnerable to the changes in the market for a longer duration.

Key Takeaways

  • Constant maturity swap refers to investment instruments that enable an investor to swap the rate of interest on a certain bond holding or account, usually on a periodic or floating basis.
  • There are various benefits of such derivatives. For example, these derivatives can maintain the same duration. Moreover, the process of booking these investment instruments is the same as that of regular interest rate swaps.
  • A key difference between a constant maturity swap and an interest rate swap is that if individuals buy the latter, they become more likely to incur losses owing to interest rate changes.

Constant Maturity Swap Explained

Constant maturity swap refers to a variation of regular interest rate swaps in which the floating portion of the investment instrument is reset at specific intervals against the rate of a fixed financial instrument. Institutions or investors looking to ensure the maintenance of a constant asset or liability duration utilize such a swap. A CMS’s floating portion leg generally periodically fixes against a certain point that one can find on the swap curve. This way, the received cash flow’s duration remains constant.

As noted above, in the case of such swaps, the maturity periods of such fixed-maturity financial instruments are longer than the reset period. Owing to this reason, investors remain vulnerable to the changes taking place in the market for a longer duration. Although this is not a negative thing, it usually indicates means such financial instruments are not recommended for individuals new to the world of investment. Often, the parties who have the most amount of interest in these swaps include financial institutions and large corporations seeking diversified funding and higher yields.

CSMs have exposure to alterations concerning interest rate movements over the long term. Organizations and individuals can utilize this exposure to place a bet on the rates’ direction or for hedging. Although people use swap rates already published as the constant maturity rates, one must remember that the most popular rates are the yields on 2-year to 5-year sovereign debt.

Generally, yield curves’ inversion or flattening once CMSs are in place improves the position of constant maturity ratepayers more compared to floating rate payers. In such scenarios, long-term rates decline more than short-term rates. Although constant maturity and floating rate payers’ relative positions are more complicated, typically fixed rate payers in swaps benefit mainly as a result of the yield curve’s upward shift.

Basic and Advanced Derivatives Course

–>> p.s. – If you want to hone your knowledge of Derivatives, then you may consider our ​​“Basics and Advanced Derivatives Bundle Course”​​ (12+ hours of video tutorials). This course covers all the crucial topics to improve your knowledge and understanding of basics to advance derivatives along with awareness as to how derivative instruments work and benefit you.

Examples

Let us look at a few constant maturity swap examples to understand the concept better:

Example #1

Suppose an investor named Jack thinks the general yield curve will likely steepen. Moreover, he expects the 6-month LIBOR (London Inter-Bank Offered Rate) rate to drop relative to the 3-year swap rate. To benefit from the alteration in the curve, Jack purchases a constant maturity swap, making payment for the 6-month LIBOR rate. In return, he receives the 3-month swap rate.

The spread arising from 2 CMS rates, for example, the 10-year CMS less 2-year CMS rates, consists of information regarding the yield curve’s slope. Because of this reason, sometimes, people refer to specific spread instruments as steepness. Derivatives that are based on any CMS spread are hence traded by parties wishing to take a position on the relative changes in the future in various parts of the yield curve.

Example #2

Suppose David thought that for a particular currency, the 6-month LIBOR rate would decrease more compared to the 3-year swap rate. To make the most of the curve’s steepness, he bought a fixed maturity swap that paid his 6-month LIBOR rate. Moreover, he received a 3-year swap rate.

Benefits

The advantages offered by such investment instruments are as follows:

  • Such swaps maintain a constant duration.
  • Determining the constant maturity by users as a point on a yield curve is possible.
  • One can book such financial instruments in an identical way as interest rate swaps.
  • Moreover, such instruments allow users to speculate on the yield curve’s movement.

Risks

Let us look at the disadvantages associated with these investment instruments.

  • There is no cap on the maximum amount of loss one can incur when using such derivatives.
  • These financial instruments are not ideal for every investor as the fluctuating interest rates make them risky.
  • Ideally, these instruments are not for inexperienced investors.
  • To use such swaps, one needs documentation from the New York City, U.S.-headquartered organization known as the International Swaps And Derivatives Association (ISDA).

Constant Maturity Swap vs Vanilla Swap

The vanilla and constant maturity swap differences are as follows:

  • In the case of vanilla swaps, the floating portion is set against the LIBOR, while the floating portion of CMS resets at fixed periods, referencing the market swap rate.
  • Another vanilla swap and constant maturity swap difference is that the latter’s prices rely on volatility, unlike the former.
  • Vanilla swaps involve users exchanging fixed interest rates for floating rate interest rates or vice versa. On the other hand, CMSs are swaps in which the floating portion is subject to a reset at fixed intervals per a set maturity rate. As a result, the investment instrument carries interest rate risk.

Constant Maturity Swap vs Interest Rate Swap

The differences between constant maturity swaps and interest rate swaps are as follows:

  • Interest rate swaps are derivative contracts that involve a couple of counterparties agreeing to exchange a future interest payment stream for another on the basis of a certain principal amount. That said, constant maturity swaps are a variation of regular interest rate swaps that smooth the volatility related to an interest rate swap by pegging a swap’s floating leg to any point on the swap curve at predetermined intervals.
  • In the case of CMSs, the purchasers of the investment instrument can fix the period of the flows they receive on the swap. However, purchasers of regular interest rate swaps cannot do the same.
  • Contrary to CMS, an interest rate swap reduces an individual’s exposure to interest rate risk.

Frequently Asked Questions (FAQs)

1. How to price a constant maturity swap?

CMS’s valuation depends on the volatility of various forward rates. Hence, it requires an approximated methodology, for example, a convexity adjustment or a stochastic yield curve model.

2. What is the duration of a constant maturity swap?

The duration will almost every time be identical to any 5-year swap. Moreover, with time, the duration remains constant, contrary to a traditional swap.

3. What is the constant maturity swap rate?

A CMS rate for any particular tenure is a point on the swap curve, which itself is a term structure in which all points on the curve are the effective par rate of swap for that specific tenor. Note that this is analogous to a three-month LIBOR curve that represents a set of forward rates for a particular tenor.

4. Why is it called a constant maturity swap?

This derivative is called CMS, as in this case, the 10-year rate is referenced every time.

This article has been a guide to what is Constant Maturity Swap. We explain its examples, comparison with interest rate and vanilla swaps, benefits, and risks. You may also find some useful articles here –

Reader Interactions

Leave a Reply

Your email address will not be published. Required fields are marked *