The CMS triangle arbitrage

A dislocation between options on constant maturity swap rates and spreads in 2009 led to a static arbitrage opportunity. Here, Paul McCloud shows how this can be detected, and how a copula-based model strategy can exploit it

For much of 2009 there was a static arbitrage in euro constant maturity swap (CMS) spread options, a consequence of the dislocation between the markets for options on CMS rates and CMS spreads. High volatility of volatility in the vanilla rates market pushed up the prices of long-dated CMS rate options, as these options are static replicated using the vanilla rates smile. In contrast, supply pressures kept the prices of CMS spread options suppressed. The requirement to maintain mark-to-market