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J W KORTH / SHOP4BONDS
A Division of JW Korth Founded 1982 | Member SIPC
Constant Maturity Swap Rates and Related Bonds and CDs
Part One – Introduction
The financial markets have seen an explosion of products that are much
different from what investors have viewed as “traditional” investments. Floaters,
inverse floaters, principal protected notes, range notes, curve steepeners, and CPI-
linked notes are among some of the types of products being offered in today’s
market. What many of these investments have in common and what makes them
different from “traditional” securities is that the return that you receive for the term
(life) of the investment depends upon the performance of an underlying index or
rate. For example, an investment that is linked to the CPI (Consumer Price Index)
typically pays the investor, periodically, a “spread” above the reference CPI rate.
The coupon may be set at +240 points above the CPI. If the current CPI rate is
3.00%, +240 would set the coupon rate for that time period at 5.40%.
Another common reference rate for many financial products is something
known as the “Constant Maturity Swap” rate. Below is an easy way of understanding
how this reference rate works.
A swap is an agreement by two counterparties in a transaction to exchange
the future stream of cash flows according to an agreed formula. How are those cash
flows determined? By their interest rate. Interest rate swaps are the most common
type of swap in the financial markets. Let’s say that Company A wants to borrow
money. They decide that the interest rate that Bank B is going to charge is
acceptable — let’s assume 4.00% for the 5 year loan. After several months, the
market conditions change. Company A finds that they would rather take advantage
of the floating rates available in the market than pay a fixed rate. At this time,
another party, Company B, is in the market looking to do the opposite. They find
that a fixed payment fits their business planning better than t