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Principles of Finance a la shmoop.. yield curves the pricing of debt so [Briefcase with yield curves on the front appears]

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we've given you the broad framework for interest rates ie the you know kissing

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cousin of inflation alright but how are they priced how are these yield curves

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formed like specifically what drives the price of renting money well there are [Man on horse whipping money]

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really two elements involved here one the odds that you'll get paid back the

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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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]

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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well here are three of them look at them and

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

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

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

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

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

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

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

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reflecting economic conditions in corporate America is called the spread

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

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

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

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

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

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three months well the annualized rate of that

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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