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Constant maturity is a type of yield that is quoted on a fixed financial instrument. This yield is used to compare a particular instrument with other financial instruments that carry similar maturity dates but different yields. Doing so makes it possible to identify how much of a return is earned as profits between the two instruments under consideration. This can often be extremely important to the financial well-being of the entity that is using the constant maturity to make the comparison, since it helps to determine whether the rate of return is sufficient to allow the lender or investor to reach his or her goals for the performance of those fixed rate instruments.
One easy way to understand how constant maturity works is to consider a bank that has determined the constant maturity rate on a one-year financial instrument is currently three percent. That rate is then compared to a loan that also has a maturity date of one year, and carries an interest rate of four percent. In this scenario, the difference between the two instruments is one percent, representing the profit margin that is realized by the bank at the time both instruments reach maturity.
Banks often use constant maturity as a means of calculating mortgage rates. The idea is to keep the interest rate applied to any mortgages written by the institution slightly ahead of maturity yields on other securities, allowing the bank to generate some sort of profit between the two instruments. The exact amount of that difference will depend on several factors, including the need to compete with other financial institutions offering fixed rate mortgages, and keeping in line with the prevailing average interest rate across the country. Unless the bank is able to generate some type of profit margin on the mortgage or other type of loan, the institution will ultimately be unable to service its customer base and will go out of business.
Governmental entities that issue bonds and similar securities also determine constant maturity as a way of understanding if those securities are generating profit or are failing. In the United States, the Federal Reserve Board uses a constant maturity in the process of quoting yields on T-bills and other types of treasury-issued securities. By making these comparisons, investors are able to compare the returns from investing in the government securities versus going with corporate bonds or securities carrying similar maturity dates. At that point, the investor can decide which option to acquire in order to earn the most return by the maturity date cited.
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