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Consistent Maturity Swap (CMS)

Constant Maturity Swap (CMS)

What Is a Constant Maturity Swap (CMS)?

A consistent maturity swap (CMS) is a variation of the ordinary interest rate swap in which the floating portion of the swap is reset periodically against the rate of a fixed maturity instrument, for example, a Treasury note, with a longer maturity than the length of the reset period. In a normal or vanilla swap, the floating portion is typically set against LIBOR, which is a short-term rate.

Put another way, the floating portion leg of a standard interest rate swap regularly resets against a distributed index. The floating leg of a steady maturity swap fixes against a point on the swap curve on a periodic basis. Along these lines, the duration of received cash flows is held steady.

Fundamentals of Constant Maturity Swap

Consistent maturity swaps are presented to changes in long-term interest rate developments, which can be utilized for hedging or as a bet on the course of rates. Albeit distributed swap rates are many times utilized as steady maturity rates, the most famous consistent maturity rates are yields on two-year to five-year sovereign debt. In the United States, swaps in view of sovereign rates are much of the time called steady maturity Treasury (CMT) swaps.

As a general rule, a leveling or an inversion of the yield curve after the swap is in place will further develop the consistent maturity rate payer's position relative to a floating rate payer. In this scenario, long-term rates decline relative to short-term rates. While the relative positions of a consistent maturity rate payer and a fixed rate payer are more complex, generally the fixed rate payer in any swap will benefit fundamentally from a vertical shift of the yield curve.

CMS in Practice

For instance, an investor accepts that the general yield curve is going to steepen while the half year LIBOR rate will fall relative to the three-year swap rate. To exploit this change in the curve, the investor purchases a consistent maturity swap paying the half year LIBOR rate and getting the three-year swap rate.

The spread between two CMS rates (e.g., the 20-year CMS rate minus the 2-year CMS rate) contains data on the incline of the yield curve. Hence, certain CMS spread instruments are once in a while called steepeners. Derivatives in light of a CMS spread are thusly traded by parties who wish to take a view on future relative changes in various parts of the yield curve.

Due to recent embarrassments and inquiries around its legitimacy as a benchmark rate, LIBOR is being phased out. As per the Federal Reserve and regulators in the U.K., LIBOR will be phased out by June 30, 2023, and will be replaced by the Secured Overnight Financing Rate (SOFR). As part of this stage out, LIBOR one-week and two-month USD LIBOR rates will presently not be distributed after December 31, 2021.

Who Uses Constant Maturity Swaps and Why?

The steady maturity swap is employed by two types of users:

  1. Investors or institutions endeavoring to hedge or take advantage of the yield curve while seeking the flexibility that the swap will give.
  2. Investors or institutions seeking to keep a consistent liability duration or steady asset.

The primary advantages and disadvantages of a consistent maturity swap are:

Pros

  • It maintains a constant duration

  • The user can determine “constant maturity” as any point on the yield curve

  • It can be booked the same way as an interest rate swap

Cons

## Features - Under a CMS, the rate on one leg of the consistent maturity swap is either fixed or reset periodically at or relative to LIBOR or another floating reference index rate. - The floating leg of a consistent maturity swap fixes against a point on the swap curve on a periodic basis with the goal that the duration of the received cash flows is held steady. - Consistent maturity swaps are interest rate swaps that smooth volatility associated with interest rate swaps by pegging the floating leg of a swap to a point on the swap curve on a periodic basis.