Hello all.I know this is a very naive question, but could someone explain to me conceptuallythe role of convexity in CMS?Thank you all in advance.

Suppose on will recieve the floating leg and pay the fixed leg of a swap which begins in 5 years and lasts, say, 10 years. Suppose the relevent swap rate (10y rate, five years forward) goes up. Then the (forward) value of the swap does not go up proportionally because as rates go up, the discounting of the payments increases. Similarly, as rates go down the (forward) value of the swap does not go down proportionally because as rates decrease, the discounting is less severe. Since a swap is a readily tradeable instrument, on average the (forward) value of the swap does not change. Therefore the swap rate itself must have a drift term. This drift term is the convexity correction of the CMS deal

Pat,thank you for your reply.My apologies but it seems i need some more hand-holding. I am not sure I understand your arguement.Your reply starts with a justifiation for the dislocation between the move of the underlying fwd swap rateand the PNL of the CMS swap. Where i am loosing you is your next statement....>Since a swap is a readily tradeable instrument, on average the (forward) value of the swap does not change. Therefore the >swap rate itself must have a drift term. This drift term is the convexity correction of the CMS dealCould you spell it out for me?Thank you as always.

I have an article (PDF) I can send you ... it does it a different way. Need a email address

Hi Pat, Would it be possible for you to mail me this article as well. Regards,Jugaljugal_parekh@yahoo.com