A constant maturity swap, often known in the financial world simply as a CMS, is an investment instrument that allows investors to “swap” the interest rate on a given account or bond holding, usually on a floating or periodic basis. In this type of swap, there is a fixed interest portion and a floating interest portion that is reset periodically against a fixed financial instrument rate, such as a treasury bill or government bond rate. The constant maturity rate swap period is almost always longer than the yield on the financial instrument to which the swap is reset. For this reason, investors are vulnerable to market changes for a longer period of time. This isn’t necessarily negative, but it often means that the instrument isn’t recommended for inexperienced or beginner investors. In most cases, the parties most interested in this kind of swapping include large corporations and financial institutions looking for higher yields and diversified funding, and life insurance companies looking to cover long-range insurance payouts.
Understanding Interest Rates Generally
Interest payments are one of the ways in which many investments prove profitable. In finance, “interest” is basically a percentage of the capital investment that is returned to the investor, usually on a set schedule. Rates of interest are determined in a couple of different ways. Sometimes they’re mandated by a fund operator or government entity. In other cases, they’re determined by market trends, and can vary based on things like amount of the total investment and the number of years the investor has held money in a certain fund.
Swapping is one way of manipulating the interest rate in order to try and maximize gains, and a CMS specifically is designed to swap against fixed or otherwise known rates. The main idea is to take advantage of temporary highs and market upticks, and it can produce significant gains — though it’s also prone to potentially large losses.
How It’s Calculated
Constant maturity rate swaps differ from standard interest rate swaps in how the investment return is calculated. Unlike a standard interest rate swap, the floating leg of a constant maturity swap is periodically reset against a fixed instrument rate, such as a bond or stock. In a standard interest rate swap, the floating leg is fixed against another interest rate, usually the London Interbank Offered Rate (LIBOR).
An investor may choose a CMS if he feels the LIBOR will fall relative to a swap rate of a certain currency over a set period of time. In this case, the investor would then buy a constant maturity swap by purchasing the LIBOR and in turn receive the swap rate for the set period. For example, the investor may purchase a six-month LIBOR to receive the three-year swap rate. This is basically a long-term bet that the swap rate will be higher then the LIBOR rate at the end of the investment period, thus yielding the investor a higher return. This type of swap is not ideal for all investors and may be considered a bit risky due to fluctuating interest rates.
Drawbacks and Risk
Inexperienced investors are not generally advised to participate in this sort of investment betting or hedging. The nature of constant maturity swaps allows for basically unlimited loss. If the LIBOR is higher than the purchased instrument at the end of the term, the investor loses the difference, no matter how high it may be. New investors who may not understand all the complex aspects could ultimately lose a lot of money. Another disadvantage of purchasing a constant maturity is that it requires documentation from the International Swaps and Derivatives Association (ISDA), which can be expensive and time consuming. Major corporations with dedicated accounting departments are usually best able to absorb these costs and burdens.