CMS spread option
A CMS spread option is similar to a regular cap/floor option. The difference is that whereas in a regular cap/floor the underlying is usually a reference rate, in a CMS spread cap/floor the underlying is the spread between the yields of two different swap rates.
How does a CMS spread cap/floor work? It usually consists of a series of options which are also known as caplets/floorlets. Each caplet/floorlet ensures the buyer protection for a single payment period. A cap protects against an increase in the spread, whereas a floor protects against an inversion or reduction in the swap rate spread. On each fixing date, if the underlying is above the strike (for a cap) or below the strike (for a floor) the buyer receives a payout.
The general formula for the payout is as follows: Max(Strike - (Gearing1*Index1 - Gearing2*Index2), 0)
Usually the underlying rates are set in-advance, i.e., it is set at the start of each payment period and paid at the end of that payment period. However, it can also be set in-arrears. That means that it is set at the end of the payment period, on the same date the payment itself is made.
What is the gearing factor? When you define swap rates to be used, you can also define what percentage of each swap rate to be used in the payout calculation. You do this by entering a number into the Gearing field. The default is 1, which represents 100%. Alternatively, you can enter, for example 0.5 which represents 50% or 1.5 which represents 150%. What are the advantages of a CMS spread option? Typically banks use CMS spread options to hedge the CMS spread swaps that they have entered into with customers.
A CMS spread option is an efficient way to exercise a view on the shape of the yield curve. In environments where the yield curve is very flat, the forecasted spread is typically around zero. However from historical analysis, yield curves tend to be characterized by low short term rates relative to longer term rates. In recent times for example, the 10 years – 2 year spread in USD has been as high as 200bp. Therefore, in markets where yield curves are currently flat, an investor could purchase a CMS spread cap based on a 10 year – 2 year spread for a relatively low price. Subsequently, if over the tenor of the option the curve normalizes, the investor will be in-the-money and generate a significant gain.