What is a Constant Maturity Swap (CMS) rate?

I have been searching in books and on the internet for a basic definition and explanation of CMS rates, but I cannot find anything clear and simple. Can you explain (maybe with an example) what a CMS rate is?

And how is it used in derivatives, such as CMS swaps, CMS caps/floors, CMS spread options?

A constant maturity swap (CMS) rate for a given tenor is referenced as a point on the Swap curve. A swap curve itself is a term structure wherein every point on the curve is the effective par swap rate for that tenor. This is analogous to a 3m LIBOR curve represents 3m forward rates for a given tenor.

A swap rate can be considered as a weighted-average of forward rates. e.g. a two year par swap rate would be the fixed rate that makes a swap on (assume) LIBOR have NPV zero at inception. Usually, a LIBOR curve (or more generically a forward curve) would be bootstrapped using swap rates in the market (usually from 2y on-wards).

For almost all derivatives you mentioned (best of my knowledge) you can liken them to their LIBOR counterpart where the reference curve is the par swap curve (effective swap rates per tenor) in lieu of the 3m LIBOR curve. e.g. a CMS swap's floating leg will (on fixing day) not refer the 3m LIBOR but the swap rate for the tenor instead.

Moreover, one could also have the other leg floating and refer to LIBOR underlying curve. E.g. a 6m LIBOR v/s 2Y CMS swap will have one leg will pay 6m LIBOR for any fixing date v/s the other leg which will pay par 2Y swap rate for the fixing date.

Wikipedia has an example mentioned as well.

• Thank you for this good explanation, it helps a lot. So a CMS rate is just an interest rate based on the swap curve instead of the LIBOR curve? Is the only purpose of CMS rates to offer longer maturities than LIBOR? – MarinD Mar 11 '16 at 18:49
• CMS rates are based on swap curve instead of libor, yes. The reason for its existence is more than just getting longer maturities tho. Swap rates themselves some form of averages on libor. So one could always swap swap rates for straight up libor. As the wiki example states, this can be used to take a position on change in libor yield curve shape. – compilation-error Mar 13 '16 at 18:05
• I keep thinking about it, but I really cannot understand why it is called "constant maturity". I understand that the maturity does not change, but in a normal swap the floating leg is also linked to a rate that has a constant maturity, e.g. swap libor 3M vs fixed rate has its floating leg referenced with the three months libor rate, and it stays three months, therefore the maturity is constant. Isn't it? – MarinD Apr 13 '16 at 12:16
• In a normal swap, the payment frequency and rate are constant, yes - so a 3M v/s fixed will always pay out 3M rates at 3M intervals (more or less). But the swap at any time will have rates from 0-3M, 3-6M, 6-9M, etc. In a CMS, each payment 'rate' is a swap rate. e.g. a 2Y swap rate would imply rates of 0-2Y (swap), 3M-2Y3M (swap), 6M-2Y6M (swap) - as if you were swapping payments from a real (constant length) swap lasting 2 years, every payment period. Hence the Constant Maturity. – compilation-error Apr 14 '16 at 0:46

In a vanilla swap, the IR on the floating leg usually depends on the reset period/swap frequency. If frequency is 6m, 6m LIBOR is used for reset, 3m LIBOR for quarterly resets etc. In a floating CMS leg, the rate used is the CMS rate, regardless of the reset frequency e.g: 10yr CMS leg will use the 10 yr CMS rate, regardless of whether the reset happens semi-annually or quarterly (of course, the rate will be multiplied by the accruing factor to make the dollar interest proportional to the length of the accruing period)

In simple terms: An ordinary swap might be a 10 year swap of Libor vs a fixed rate; this fixed rate is determined in the marketplace every day and is published by Reuters, Bloomberg etc. as the '10 year swap rate'. Once you enter into the swap this rate remains fixed for you, of course, that is why it is called a fixed rate. But every day Reuters publishes a new number for 5 year swaps, 10 year swaps, etc.

A CMS swap is a kind of second order swap where you swap a rate of your choice against the above mentioned '10 year swap rate'. Every once in a while the rate is changed by referencing whatever Reuters says on that date the '10 year swap rate' is. Because it is always the 10 year rate that is referenced, it is called a constant maturity (in this case 10 year maturity) swap. Your payments however vary depending on developments in the market for ordinary swaps.

• Thanks a lot. I still don't understand why it is called "Constant Maturity": the maturity is fixed indeed, but it iss also fixed for a LIBOR rate. For example the LIBOR 6M rate has a constant maturity of 6 months. It seems to me that it is only a longer-term rate than LIBOR. Isn't it? – MarinD Mar 11 '16 at 19:04