The Yield Curve Swap – (originally published Q3-2006)
Overview
Since late March, the tax exempt market has been inundated with a strategy designed to increase the cash flow from a LIBOR based swap.
The transaction goes by the several different names including:
- Constant Maturity Swap (“CMS”)
- Basis Swap Overlay
- Yield Curve Swap (“YCS”)
- Increased Tenor Swap
We will refer to the swap in this paper as the YCS, but in all its incarnations, at its most basic level, the trade is extremely simple convert the receipt of 1 month LIBOR to the receipt of longer term LIBOR (usually either 5 year or 10 year). The timing of the execution of the trade is based on the current flatness of the yield curve (currently there is very little difference between the cash flows associated with 1 month LIBOR and 5 Year LIBOR). Since the yield curve is normally upward sloping, many anticipate that the upward bias of the curve will return at some point resulting in greater cash flow.
Implementation
For purposes of this paper, we will focus on the simplest version of the trade – converting 67% of 1 month LIBOR to X% of 5 year LIBOR with “X” equal to the market determined conversion rate. Although the analyses are largely the same, dealers are proposing amending existing confirms to convert 67% of 1 month LIBOR to:
- X% of 5 year LIBOR
- X% of 10 year LIBOR
- 67% of 5 or 10 year LIBOR less X basis points
- A delayed or forward start on the above
- A separate confirm with the client paying 67% of LIBOR and
receiving any of the above.