Principles of Finance: Unit 2, Yield Curves: The Pricing of Debt

What are yield curves, and why are they so yield-y? We'll explain the four flavors of yield curve: normal, flat, inverse, and mocha chip.

CoursesFinance Concepts
Principles of Finance
FinanceFinancial Responsibility
Personal Finance
Finance and EconomicsPrinciples of Finance
LanguageEnglish Language
Life SkillsPersonal Finance
SubjectsFinance and Economics

Transcript

00:31

money you just loaned if you're the bank loaning out the money and two the time

00:37

it'll take you to get paid back the money you just loaned out well these two

00:41

things are linked but well let's just focus on risk for now if a buddy asks

00:46

you for 10 bucks for lunch and tells you she'll pay you back tomorrow and you're [Girl asks friend for $10]

00:51

at work on a Tuesday and you know it's highly likely you'll see her Wednesday

00:56

well her 10 dollar loan is probably money good meaning that the risk of not

01:01

being paid back that 10 bucks is low but what if she wanted to borrow $1,000 [Girl asking friend for $1000]

01:07

while she goes off with Bjorn for a lovely summer in the Swedish

01:11

Highlands well she'll be coming back to work afterwards but man that Bjorn guy

01:16

is good-looking and in the back of your mind you're wondering if well she'll [Girl and Bjorn eating a picnic]

01:20

just stay in Sweden forever and you might not see her again well maybe you'd

01:24

still loan her the money but now you're gonna miss that grand for a whole summer

01:30

and there was all this stuff you wanted to go buy with it and now your earring

01:35

rep will go hungry so maybe you charge her some real interest like well 5% on

01:41

that money so when she comes back she has to pay you a thousand 50....50

01:46

bucks for renting the money for a quarter of a year that's a 20 percent

01:50

annualized rate got it no it's not okay to just give you back your grand and a [Woman with money and a FedEx box]

01:54

lousy t-shirt at the end that says my friend went to Sweden with a guy named

01:59

Bjorn and all I got was this lousy t-shirt although that'd be kind of a

02:04

cool t-shirt I think Anyway same as above only now

02:08

she wants to borrow 10 grand wow that's a lot of money could she ever pay that

02:12

back well one more time same as above only now she wants to borrow 20 grand [Girl watching a Deer and Elvis]

02:17

for the reindeer Platinum Elvis wedding in neighboring Helsinki and she'll give

02:23

you your 5% but she wants 20 years to pay you back lots of risk there if she

02:29

ever doesn't pay you back well how on earth do you call collections in Sweden [Men with bats appear beside woman]

02:34

ie the burly guys with baseball bats who visit your home to collect from bad

02:39

poker hands on your once besties are you really gonna do that and make that call

02:44

but if you had to like if you were a commercial bank or something well you'd

02:49

want to charge a lot of interest like say maybe you'd charge

02:53

I don't know 15% interest a year at least that way if she made payments for [Girl opens mailbox]

02:57

six or seven years while you'd at least have collected most of your initial

03:02

principal before she disappeared on a Viking ship [Girl with Bjorn on a viking ship]

03:05

so that's risk premium you'll charge a premium beyond the very safe next day

03:12

hamburger ten dollar rate to make up for the odds that your buddy just goes away

03:18

and never pays you back what's the hamburger rate in real life well it's [Woman working at hamburger store]

03:22

called LIBOR and it stands for the London interbank offering rate LIBOR

03:28

there you go it's generally how the Western world sets interest rates today [Woman spins a wheel of interest]

03:31

with a lot of input from the US federal government ...The Fed well that

03:36

hamburger rate is basically just the best rate or the best price of renting

03:41

money to the banks best credit risk customers like if you're loaning not a [Woman gives money to man called Google]

03:47

lot of money to Google for a year it's highly likely they'll pay you back so

03:51

they don't have to pay a lot of rent on that money you just loaned them

03:55

that's the hamburger rate and everything higher than that is risk premium all [Hamburgers stacked on top of each other]

04:00

right well these rates can be understood through yield curves...

04:04

well here are three of them look at them and

04:07

see if you can figure out on your own what they're telling us here's a normal [three example yield curves]

04:11

yield curve... you can see the yield is low when the

04:15

time is short presumably a little bit less risk right if you're gonna collect

04:19

quickly from someone then there's an inverse yield curve like where rates are

04:23

super high today but they get cheaper in the future and then there's kind of a

04:27

flattish looking yield curve there where nobody really cares about the duration....

04:36

well the GPS navigation device in figuring out how the bond market is [GPS screen in car appears]

04:40

reflecting economic conditions in corporate America is called the spread

04:45

to Treasuries because it is US Treasury bills that are the hamburger rate in

04:51

most US based debt transactions so let's start with normal alright in non special

04:59

debt times short interest rates are lower than long term rates like that's [Normal yield curve graph appears]

05:04

normal that's not some crazy economic event has happened that changes the

05:08

price of renting money that means that a person X wants to borrow money for

05:12

three months well the annualized rate of that

05:16

borrowing is lower than if the same person X under the same terms wants

05:21

to borrow money for 30 years right.. three months that per month rent is cheaper

05:26

than the per month rent for thirty years why well because person X could die her [Person X drops off the chart]

05:31

company could go bankrupt she could disappear lots of bad things could

05:35

happen in that 30 year time frame so most lenders are much happier with

05:40

shorter term borrowings so they priced that debt cheaper and that's what you

05:45

see in this yield curve got it? cheaper here more expensive there so then how

05:49

does the opposite happen ie what's the deal with the inverted

05:53

yield curve thing... well let's go back in history well when Jimmy [Man enters door]

05:57

Carter wanted to stamp out inflation and cool down the economy quickly he made [Jimmy Carter pours water on inflation]

06:02

the cost of short-term money borrowing extremely expensive like 12% annualized

06:09

rate kind of expensive and thats for the best customers just for scale here in

06:14

most of the modern era short-term money has cost closer to 1% not 12... [Giant Jimmy Carter terrorizing the city]

06:20

well you wanted to borrow money for ten years cost maybe 10% in 30 years it was

06:26

maybe 8% got it so that's an inverted yield curve it looks like that and to

06:31

think about it the markets were betting that Carter would be successful in

06:36

cooling down the economy near-term and that some years later rates would fall [Raegan sitting in office]

06:41

and the curve would return to its normal shape or at least yields would return to

06:47

their normal prices and that's exactly what happened but for a while we had

06:51

this weird looking inverted yield curve from the late 1970s until reaganomics

06:55

really took hold in the early 80s all right last but not least is the flat

07:01

yield curve well that's what it looks like right there and when a yield curve

07:05

is flat it's telling you that the market just doesn't care whether dead is short [Flat yield curve appears]

07:09

medium or long term means that the market thinks that rates will be pretty

07:13

steady for a long time flat yield curves don't happen all that often but when

07:18

they do well it's kind of a harvest movement of finance... [Man talking about flat yield curves and a wolf man appears]