1 00:00:00,000 --> 00:00:08,000 Alan Cring Productions in association with Emergent Light Studio presents 2 00:00:10,000 --> 00:00:16,000 the Illinois State Collegiate Compendium, academic lectures in business and economics. 3 00:00:17,000 --> 00:00:23,000 This is Business Finance, FIL 190 for spring semester 2024. 4 00:00:23,000 --> 00:00:28,000 Music 5 00:00:28,000 --> 00:00:39,000 Today, interest rates. I'll do one quick thing with Excel to show you a little upgrade that I made to that present value and future value sheet. 6 00:00:39,000 --> 00:00:44,000 Just so you're aware of that, and then we'll move on from there. 7 00:00:44,000 --> 00:00:55,000 But always, as always, we will look at the numbers. And the numbers are not particularly pleasant. 8 00:00:55,000 --> 00:01:09,000 Definitely, this is a bare day. And we've had a couple of them in a row, sort of a run of them over the past week or so. 9 00:01:09,000 --> 00:01:14,000 It's nothing really to panic about, but there's just not a lot of happy news. 10 00:01:14,000 --> 00:01:21,000 As you can see, the Dow and the S&P 500 are down a quarter of a percent in the early trading here this morning. 11 00:01:21,000 --> 00:01:28,000 The NASDAQ is down more, which you would expect, higher risk portfolio and all that good stuff. 12 00:01:28,000 --> 00:01:37,000 But like I said, this is not some massive sell-off. It's just grouchy the markets are right now. 13 00:01:37,000 --> 00:01:43,000 Kind of not seeing all kinds of happy news to make them go up. 14 00:01:43,000 --> 00:02:00,000 But if we go over here and have a look while crude, it had gotten above that 72 to 79 long-standing trading bear area, and now it's back into it. 15 00:02:00,000 --> 00:02:06,000 And so that's kind of good news. It's still a little on the high side of the trading area. 16 00:02:06,000 --> 00:02:16,000 But it's definitely, it chickened out. It got up to that neckline, got up on the other side of it, and didn't like what it saw, and then came back down through. 17 00:02:16,000 --> 00:02:24,000 But it is up a little bit in the trading that's been going on since the oil markets opened again last night. 18 00:02:24,000 --> 00:02:33,000 So it's there. The gold is still sitting there above the 2,000, but it's not really doing anything that we could worry too much about. 19 00:02:33,000 --> 00:02:39,000 Now coming over here, the 10-year bond is down. It's down a tiny bit. 20 00:02:39,000 --> 00:02:45,000 The yields are down two-tenths of a basis point. So that's like saying nothing. 21 00:02:45,000 --> 00:02:49,000 It's just almost a flat day right now in the bonds. 22 00:02:49,000 --> 00:02:57,000 It would be nice if we saw the yields going down with demand for bonds going up and pushing the prices up. 23 00:02:57,000 --> 00:03:04,000 But it's not doing that right now. It's just kind of sitting there. Actually, now it's flat on its back. 24 00:03:04,000 --> 00:03:09,000 So there's that. Kind of curious about what was going on over in the other part of the world. 25 00:03:09,000 --> 00:03:20,000 The Nikkei, now you see all that red, but if you look at the percentage from open to close, it was down only a quarter of a percent. 26 00:03:20,000 --> 00:03:27,000 So even though that looks like a bad day, it's really not anything impressive at all. 27 00:03:27,000 --> 00:03:35,000 The markets are just, and you can see over in London later, London just kind of, it's still trading now, but it's about the end of the day. 28 00:03:35,000 --> 00:03:45,000 It started off down and then it just drifted. It's one of those days when the markets are just in a grouchy mood, as you can see, across the globe. 29 00:03:45,000 --> 00:03:54,000 And here over here we see the same thing. Markets are just kind of down a little bit, being crabby about what's going on in the world, 30 00:03:54,000 --> 00:03:59,000 not really being too impressed by anything that's going on. 31 00:03:59,000 --> 00:04:05,000 So we just kind of sit here and wait for some kind of news one way or the other. 32 00:04:05,000 --> 00:04:15,000 Now we'll have some reports coming out next month, of course, inflation report, and we're expecting that to still be under control. 33 00:04:15,000 --> 00:04:21,000 That's good news. And a few other numbers, manufacturing will be coming out. 34 00:04:21,000 --> 00:04:31,000 But there's nothing that's really going to motivate the markets more than just a sustained improvement in the economy. 35 00:04:31,000 --> 00:04:35,000 So that's about all we can say about it in a day like this. 36 00:04:35,000 --> 00:04:42,000 Remember that you don't always have to have some exciting story to tell when you're an analyst. 37 00:04:42,000 --> 00:04:51,000 Actually, the less excitement you have, the better in our world, unless you're an options or futures trader. 38 00:04:51,000 --> 00:04:55,000 But in our world, quiet is kind of a nice thing. 39 00:04:55,000 --> 00:05:05,000 One thing that I meant to show you, let's look at the VIX. Remember that the VIX shows volatility, the vol of the market. 40 00:05:05,000 --> 00:05:13,000 We go over here, VIX, CBOE volatility index. 41 00:05:13,000 --> 00:05:20,000 Really not much of a...we had a little spike there, and we're right now seeing the one day. 42 00:05:20,000 --> 00:05:29,000 Now, notice that this is a market that is open all the time. This doesn't go by a trading bell. It's a volatility. 43 00:05:29,000 --> 00:05:41,000 It's based upon a lot of factors. Some of them would be equities and bonds, but there are other securities and quasi-securities that go into it. 44 00:05:41,000 --> 00:05:56,000 And so since the beginning of the trading day, there was a spike there. About when the sun was coming up this morning, a little before the sun came up, something got the VIX really excited. 45 00:05:56,000 --> 00:06:04,000 But if you look over here at the one month on the VIX, you see that there's been a kind of a trend upward. 46 00:06:04,000 --> 00:06:15,000 You see that short-term trend upward in the volatility of the market. That's an indicator that more uncertainty. 47 00:06:15,000 --> 00:06:22,000 We don't know where things are going, and that is best reflected in the volatility index. 48 00:06:22,000 --> 00:06:33,000 And as you can see, what the hell was that spike there? Good grief. I don't know what that was, but it certainly got...something got the market excited. 49 00:06:33,000 --> 00:06:41,000 But for the most part, it just kind of floats along there, just looking stupid, wondering what it should do next. 50 00:06:41,000 --> 00:06:54,000 And if you are into that kind of a world where you're looking more at volatility, which way is it going to go, then you would want to...I think I brought this up before. 51 00:06:54,000 --> 00:07:13,000 SQQ is very much a...this is a bear security. And it wins when the vol is showing a lot of negativity in it. 52 00:07:13,000 --> 00:07:21,000 And as you can see, today it's up a little bit because it's a bear day, as you saw from the original numbers, the indexes. 53 00:07:21,000 --> 00:07:31,000 And so this would be one that if you are a bear, this would be a broad, broad bet that you were right. 54 00:07:31,000 --> 00:07:45,000 Now if you're a bull, you might look at something like TQQQ. And you can see, surprise, surprise, it's down today because it is not a bull market today. 55 00:07:45,000 --> 00:07:55,000 These are not straight up bets on stocks. These are bets on directions of securities in general. 56 00:07:55,000 --> 00:08:07,000 And so these are more those kinds of things that if you see the...want to deal with the larger picture and not with the individual stocks and hoping to God they do what you want them to, 57 00:08:07,000 --> 00:08:20,000 then these are the kind of instruments that you would want to work with in your own investing or in the investing if you were making recommendations for people 58 00:08:20,000 --> 00:08:27,000 and you didn't want to step into the snake pit of individual stocks and where they're going to go. 59 00:08:27,000 --> 00:08:33,000 So just keep that in mind for something to put in your hat for a potential investment. 60 00:08:33,000 --> 00:08:44,000 And there are options on these too. And the options can be really nasty or great because these are already magnifiers. 61 00:08:44,000 --> 00:08:54,000 SQQQ, TQQQ are already magnifying market movements. And if you go to the options, those are magnifying them again. 62 00:08:54,000 --> 00:09:03,000 And so these can be either real winners or in my case the primary reasons you're in bankruptcy. 63 00:09:03,000 --> 00:09:15,000 But keep that in mind as you do your investments. And there is a whole world of investment alternatives that you have that are not just stocks and bonds. 64 00:09:15,000 --> 00:09:20,000 And we'll get into a little more of that and especially into how you trade with those. 65 00:09:20,000 --> 00:09:30,000 Now let me do something here. We're going to get off this horse for a while here and go over here to something. 66 00:09:30,000 --> 00:09:40,000 Now I keep improving these templates that you're using and I've done one last improvement on the internal rate of return, 67 00:09:40,000 --> 00:09:54,000 I'm sorry, on the present values and future values tables, spreadsheets, I'm sorry. And over here let's have a look where the heck is it. 68 00:09:54,000 --> 00:10:01,000 Present value and future values. 69 00:10:01,000 --> 00:10:16,000 Now I do that all the time. Instead of downloading it, I click on it and then you don't, it's just a preview. Okay, here we go. 70 00:10:16,000 --> 00:10:21,000 Let me come up here. 71 00:10:21,000 --> 00:10:31,000 Well, I haven't downloaded it to you yet. Let me do it over here. I will fix this Leaves student view. Bear with me. 72 00:10:31,000 --> 00:10:39,000 I must have downloaded it to the 240 courses instead of to yours. Yours is a little bit more robust version of it. 73 00:10:39,000 --> 00:10:45,000 But I must have downloaded your version over here, files, and I'll re-upload it to yours here. 74 00:10:45,000 --> 00:10:55,000 Spreadsheets, present value, and future value. There we go. That's the one. Download. 75 00:10:55,000 --> 00:11:00,000 And now I'll re-upload this one, finish with it. 76 00:11:00,000 --> 00:11:10,000 Okay, good. I'm going to have to reduce the scale of this a little bit so you can see it all. 77 00:11:10,000 --> 00:11:24,000 Now, here you will see that the main thing that I did was I have written one more routine that will find the balance on a loan. 78 00:11:24,000 --> 00:11:35,000 See here in the middle, you can calculate loan payments. Well, this one right here, this will also allow you to calculate the balance on a loan. 79 00:11:35,000 --> 00:11:40,000 What's due still on the loan after a certain number of years. 80 00:11:40,000 --> 00:11:46,000 So, for example, if I were to say the... 81 00:11:46,000 --> 00:12:12,000 We borrow on a six-year loan with monthly payments and an APR of, let's say, 5.89%, and we're going to borrow a total of...we're going to buy a car for $35,000. 82 00:12:12,000 --> 00:12:18,000 And let's...whoops. Okay, there's your payments, $578 a month. 83 00:12:18,000 --> 00:12:28,000 Now, let's see how much we still owe after three years on that car. 84 00:12:28,000 --> 00:12:32,000 It will be $19,000 about. 85 00:12:32,000 --> 00:12:43,000 Well, how much after four years? And after five years? 86 00:12:43,000 --> 00:12:50,000 And then finally, we should see a zero at six years. Yep, we do. 87 00:12:50,000 --> 00:12:59,000 So that's just a little augmentation. Now, let me show...let me point out to you this formula right here. 88 00:12:59,000 --> 00:13:06,000 Let me turn down these lights so you can see this a little better. 89 00:13:06,000 --> 00:13:09,000 There we go. 90 00:13:09,000 --> 00:13:15,000 That Excel formula is surprisingly odd. 91 00:13:15,000 --> 00:13:25,000 Excel does not have an embedded balance on a loan formula. 92 00:13:25,000 --> 00:13:29,000 It doesn't have it, which is kind of weird that it wouldn't have it. 93 00:13:29,000 --> 00:13:34,000 So you have to think about how a loan works. 94 00:13:34,000 --> 00:13:42,000 And in fact, what I...if you'll notice here, I am actually calculating a future value. 95 00:13:42,000 --> 00:13:49,000 Now, the future value, the rate, is obvious. The APR divided by the number of periods per year. 96 00:13:49,000 --> 00:13:53,000 So in this case, 5.89 divided by 12. 97 00:13:53,000 --> 00:13:58,000 Now, the next one would be the number of periods, 98 00:13:58,000 --> 00:14:08,000 which in this case would be the number of years remaining times the periods per year. 99 00:14:08,000 --> 00:14:20,000 So if I were to put in here that 4 again... 100 00:14:20,000 --> 00:14:25,000 Now, the next thing that you're going to see in this formula are the payments. 101 00:14:25,000 --> 00:14:29,000 Well, that was what was calculated up here. 102 00:14:29,000 --> 00:14:32,000 You have to do this part first before this will work. 103 00:14:32,000 --> 00:14:34,000 But you calculated the payments here. 104 00:14:34,000 --> 00:14:41,000 So then I'm going to call those payments right here as part of this future value formula. 105 00:14:41,000 --> 00:14:50,000 And then D7 will be what the original amount was. 106 00:14:50,000 --> 00:14:55,000 So basically what I'm doing is from the start, 107 00:14:55,000 --> 00:15:03,000 I'm seeing what the future value of 4 times 12, or 48 payments, would be 108 00:15:03,000 --> 00:15:14,000 if you started out with that D5 amount of money, I'm sorry, with the original present value, the D7. 109 00:15:14,000 --> 00:15:19,000 So in other words, you just wouldn't expect it to be this way 110 00:15:19,000 --> 00:15:28,000 because the loan payments themselves, as you see, is a present value of an annuity to calculate the payments. 111 00:15:28,000 --> 00:15:34,000 But once you know the payments, then what this formula is actually doing is taking you forward. 112 00:15:34,000 --> 00:15:44,000 If you originally owed $35,000, what would be the future value at 4 years, for example, 113 00:15:44,000 --> 00:15:51,000 of how much you had paid in payments to that point? 114 00:15:51,000 --> 00:15:59,000 It's odd. And that's one of the things that you'll find in Excel. 115 00:15:59,000 --> 00:16:03,000 There's almost always a way to get something done. 116 00:16:03,000 --> 00:16:07,000 But sometimes you have to think in a very unusual way. 117 00:16:07,000 --> 00:16:12,000 Now, would I expect any of you to be able to do this even at the end of this court? Probably not. 118 00:16:12,000 --> 00:16:23,000 I wouldn't. But I'm just showing you that take Excel and think about the finance behind it. 119 00:16:23,000 --> 00:16:30,000 A balance is actually the future value of what you originally borrowed 120 00:16:30,000 --> 00:16:38,000 given that you have put a certain number of payments in already by that future point in time. 121 00:16:38,000 --> 00:16:41,000 That's how you have to think of a balance on a loan. 122 00:16:41,000 --> 00:16:44,000 It's not a present value of any kind. It's a future value. 123 00:16:44,000 --> 00:16:53,000 In 4 years, I owed this much. In 4 years times 12 payments a year, I've made these payments. 124 00:16:53,000 --> 00:16:59,000 So what would be the remaining amount at that point in time? 125 00:16:59,000 --> 00:17:03,000 I just noticed a little bit of something I did there. 126 00:17:03,000 --> 00:17:09,000 I should have put right there, breaking my own rule. 127 00:17:09,000 --> 00:17:11,000 Do you see what I did wrong there? 128 00:17:11,000 --> 00:17:17,000 You get the right answer. But do you see what I did that's sloppy? 129 00:17:17,000 --> 00:17:21,000 Look at the formula. Look where my cursor is. 130 00:17:21,000 --> 00:17:25,000 Remember I said you should never have numbers in a formula? 131 00:17:25,000 --> 00:17:28,000 Well, there I did it and I didn't need to. 132 00:17:28,000 --> 00:17:32,000 What should I have put there? 133 00:17:32,000 --> 00:17:33,000 D8. 134 00:17:33,000 --> 00:17:34,000 What? 135 00:17:34,000 --> 00:17:35,000 D8. 136 00:17:35,000 --> 00:17:43,000 Damn straight. I should have put a D8 in there. 137 00:17:43,000 --> 00:17:47,000 There you go. I got sloppy. 138 00:17:47,000 --> 00:17:53,000 So now, you see, now I have a formula that has no numbers in it whatsoever. 139 00:17:53,000 --> 00:17:59,000 They are called by reference to other places in the spreadsheet. 140 00:17:59,000 --> 00:18:03,000 I don't know. I must have been drunk or something. 141 00:18:03,000 --> 00:18:07,000 I just didn't think about it. But there you go. 142 00:18:07,000 --> 00:18:12,000 Now, there's something else that I want to look at here. 143 00:18:12,000 --> 00:18:25,000 I had done a little repair. Let me look here. 144 00:18:25,000 --> 00:18:28,000 There's 7. D7. 145 00:18:28,000 --> 00:18:32,000 Did I fix that? F7? 146 00:18:32,000 --> 00:18:35,000 I sure did. Now, let me show you. 147 00:18:35,000 --> 00:18:46,000 Suppose that you wanted, you will receive $25,000 in 9 years. 148 00:18:46,000 --> 00:18:53,000 That's all. $27,000 in 9 years. 149 00:18:53,000 --> 00:18:59,000 So your future value is going to be $27,000. 150 00:18:59,000 --> 00:19:05,000 You will put any payments into it. 151 00:19:05,000 --> 00:19:13,000 Let's say the APR is 2.89%. 152 00:19:13,000 --> 00:19:27,000 Now, this is for 9 years. Let's say it's compounded semi-annually. 153 00:19:27,000 --> 00:19:31,000 The present value of it is that. 154 00:19:31,000 --> 00:19:38,000 So in other words, in this application, I'm violating my own orange rule there. 155 00:19:38,000 --> 00:19:50,000 If all you need to do is a lump sum, then what you do is you put that lump sum in the future value slot. 156 00:19:50,000 --> 00:19:56,000 And then you clear out the payments if it's just a lump sum. 157 00:19:56,000 --> 00:20:05,000 So that's all you do to get a lump sum if it's a present value of a lump sum instead of the present value of an annuity. 158 00:20:05,000 --> 00:20:08,000 Now, take it the other way. What about a future value? 159 00:20:08,000 --> 00:20:27,000 Let's say that in 15 years, taking let's say 3.75% interest compounded semi-annually, 160 00:20:27,000 --> 00:20:42,000 I want to know what the present value, what's the future value of let's say $20,000 is. 161 00:20:42,000 --> 00:20:48,000 Oh, I forgot to put a zero there. You have no payments. I was going to say that's way too much. 162 00:20:48,000 --> 00:20:56,000 There you go. So if you want to calculate a lump sum, you zero out the payments. 163 00:20:56,000 --> 00:21:02,000 And then if it's for a future value, you put in the original amount. 164 00:21:02,000 --> 00:21:05,000 And if it's for a present value, you put in the future amount. 165 00:21:05,000 --> 00:21:12,000 And you can get lump sums in this formula that I've done here. 166 00:21:12,000 --> 00:21:14,000 So it can do it both ways. 167 00:21:14,000 --> 00:21:19,000 Now, I would strongly encourage you to master this spreadsheet. 168 00:21:19,000 --> 00:21:29,000 Because if you can master it, you can answer most of the quantitative questions on the midterm exam. 169 00:21:29,000 --> 00:21:33,000 All you have to do is learn how to play with this table. 170 00:21:33,000 --> 00:21:40,000 And you can even get effective rates on money from this table as well. 171 00:21:40,000 --> 00:21:50,000 So this one table will clear out a chapter of formulas and replace tables that you would use 172 00:21:50,000 --> 00:21:55,000 or financial calculators that you could use all in this one table. 173 00:21:55,000 --> 00:21:58,000 So it's worth it for you to master this table. 174 00:21:58,000 --> 00:22:09,000 Play with it. Try it out. See if you can get it to do all the stupid pet tricks I've put in there. 175 00:22:09,000 --> 00:22:14,000 And that's that. 176 00:22:14,000 --> 00:22:17,000 Now I don't want to save that. 177 00:22:17,000 --> 00:22:22,000 Let me do something here real quick. 178 00:22:22,000 --> 00:22:26,000 Let me get that back up there. 179 00:22:26,000 --> 00:22:33,000 And let me fix that balance thing right there. 180 00:22:33,000 --> 00:22:41,000 D8 del D8. 181 00:22:41,000 --> 00:22:45,000 And then let me save this. 182 00:22:45,000 --> 00:22:50,000 And take it back over to Canvas here. 183 00:22:50,000 --> 00:22:54,000 Nope, I don't want to do that. 184 00:22:54,000 --> 00:22:57,000 Actually, I wanted you to put it in your section. 185 00:22:57,000 --> 00:23:08,000 Because I'm not doing this one quite like quite this much. Files, spreadsheets, 186 00:23:08,000 --> 00:23:14,000 upload, and then there it is. 187 00:23:14,000 --> 00:23:20,000 And then let me fix this. Delete the original. 188 00:23:20,000 --> 00:23:32,000 And then change the name of this one to just straight up. 189 00:23:32,000 --> 00:23:35,000 There you go. Now it's in your files. 190 00:23:35,000 --> 00:23:39,000 And this is the freshest, cleanest one of all of them. 191 00:23:39,000 --> 00:23:43,000 All for you. 192 00:23:43,000 --> 00:23:49,000 Now the topic of today's lecture is interest rates. 193 00:23:49,000 --> 00:23:56,000 And as I've already gone through interest rates to a certain extent with you, 194 00:23:56,000 --> 00:24:01,000 interest rates are rental rates on money or capital. 195 00:24:01,000 --> 00:24:07,000 And the one thing about interest rates is that they are, 196 00:24:07,000 --> 00:24:11,000 there are many of those interest rates. 197 00:24:11,000 --> 00:24:15,000 They are not, there's not the interest rate. 198 00:24:15,000 --> 00:24:19,000 There are interest rates on car loans, credit cards, 199 00:24:19,000 --> 00:24:23,000 interest rates that companies pay on their bond issues, 200 00:24:23,000 --> 00:24:27,000 interest rates that are paid on short-term borrowings, 201 00:24:27,000 --> 00:24:30,000 interest rates that banks pay you, 202 00:24:30,000 --> 00:24:37,000 interest rates that banks charge a corporation versus what they charge you, 203 00:24:37,000 --> 00:24:41,000 interest rates on treasury debt. 204 00:24:41,000 --> 00:24:44,000 There are all kinds of interest rates. 205 00:24:44,000 --> 00:24:50,000 We work on the theoretical foundation. 206 00:24:50,000 --> 00:24:57,000 And it's theoretical because we can't have a truth underneath this. 207 00:24:57,000 --> 00:25:03,000 There is not a foundation interest rate underneath that we can see. 208 00:25:03,000 --> 00:25:08,000 It's one of those theoretical objects that we know has to be there 209 00:25:08,000 --> 00:25:12,000 because all these other interest rates are on top of something 210 00:25:12,000 --> 00:25:16,000 that is at the bottom of the pile. 211 00:25:16,000 --> 00:25:22,000 Very much like in the 1950s, in a completely different field, 212 00:25:22,000 --> 00:25:29,000 we knew that there was something called DNA, deoxyribonucleic acid. 213 00:25:29,000 --> 00:25:34,000 We knew that it was the driving force that shaped what a creature looked like. 214 00:25:34,000 --> 00:25:36,000 But we've never seen it. 215 00:25:36,000 --> 00:25:44,000 We knew it was there because we knew what its effects were. 216 00:25:44,000 --> 00:25:47,000 One of the triumphs of the modern age, 217 00:25:47,000 --> 00:25:50,000 and it was published in textbooks in my time, 218 00:25:50,000 --> 00:25:57,000 was the first time that a scanning electron microscope managed to actually get a photograph of it. 219 00:25:57,000 --> 00:25:59,000 And then finally we saw it. 220 00:25:59,000 --> 00:26:02,000 We knew what it looked like even. 221 00:26:02,000 --> 00:26:07,000 But, boy, when we saw that photograph, well, apparently it works that way. 222 00:26:07,000 --> 00:26:12,000 Okay. 223 00:26:12,000 --> 00:26:29,000 We call that substrate interest rate the risk-free rate. 224 00:26:29,000 --> 00:26:36,000 R sub f. 225 00:26:36,000 --> 00:26:38,000 Now we can't even see that. 226 00:26:38,000 --> 00:26:43,000 We know that that thing actually has two pieces to it. 227 00:26:43,000 --> 00:26:47,000 We can't see R sub f. 228 00:26:47,000 --> 00:26:51,000 So we certainly cannot see those two pieces that it has in it. 229 00:26:51,000 --> 00:26:56,000 Now understand that we can find something that is very, 230 00:26:56,000 --> 00:26:59,000 very close to the risk-free rate. 231 00:26:59,000 --> 00:27:05,000 In other words, just the pure opportunity cost of foregone consumption. 232 00:27:05,000 --> 00:27:16,000 We generally, for this purpose, we would take the risk-free rate is somewhere very close to the rate, 233 00:27:16,000 --> 00:27:24,000 the yield on a short-term United States Treasury bill. 234 00:27:24,000 --> 00:27:31,000 So in other words, we will use risk-free rate in a number of calculations in this class as time goes along. 235 00:27:31,000 --> 00:27:44,000 So in order to use it, we use this proxy, which is the yield on a short-term Treasury bill. 236 00:27:44,000 --> 00:27:57,000 And I'm going to show you over the next few minutes, well, a little bit later, that this is the U.S. 237 00:27:57,000 --> 00:28:04,000 And I'm going to put a link to this for you in your Canvas and also in the scrolling marquee on my website. 238 00:28:04,000 --> 00:28:07,000 But these are the yields from the beginning of the year. 239 00:28:07,000 --> 00:28:22,000 Now, generally, the one that we look at is the one-year Treasury bill rate, the yield on a one-year T bill as the proxy for R sub F. 240 00:28:22,000 --> 00:28:30,000 Now, as you can see, this thing was bouncing around early in the year and it's still up there. 241 00:28:30,000 --> 00:28:43,000 It's below 5 percent, but you notice that it doesn't seem to have a lot of will to go stay down. 242 00:28:43,000 --> 00:28:51,000 So that would mean that this substrate rate is probably having a little bit of volatility, 243 00:28:51,000 --> 00:28:55,000 uncertainty about Federal Reserve policy and all of that. 244 00:28:55,000 --> 00:29:06,000 Well, that's fine. But what about this R sub F? What's in there? 245 00:29:06,000 --> 00:29:15,000 Well, we know two things are in there. There is a real interest rate. 246 00:29:15,000 --> 00:29:21,000 In other words, it does not embed inflation. 247 00:29:21,000 --> 00:29:28,000 It is just purely the supply and demand dynamics of money. 248 00:29:28,000 --> 00:29:39,000 Where supply of money meets the demand for money, that is the real interest rate. 249 00:29:39,000 --> 00:29:50,000 But then also in there would be this expected inflation premium. 250 00:29:50,000 --> 00:29:55,000 Now, the book calls this IP, inflation premium. That's not correct. 251 00:29:55,000 --> 00:30:01,000 And even they make sure that you know that this is not the inflation rate. 252 00:30:01,000 --> 00:30:05,000 If it were, it would be easy. We could just measure it. 253 00:30:05,000 --> 00:30:10,000 It is the expected inflation premium. 254 00:30:10,000 --> 00:30:16,000 What that means is that interest rates are not driven by inflation. 255 00:30:16,000 --> 00:30:21,000 They are driven by the expectation of inflation. 256 00:30:21,000 --> 00:30:26,000 That's absolutely critical that you understand that in finance. 257 00:30:26,000 --> 00:30:31,000 We know that markets don't give a rat's ass about history. 258 00:30:31,000 --> 00:30:35,000 They want to know what is going to happen next. 259 00:30:35,000 --> 00:30:40,000 So here we will take a brief example. 260 00:30:40,000 --> 00:30:47,000 I have decided that I am going to hire you for my company. 261 00:30:47,000 --> 00:30:54,000 I figure, you look like you are very well educated and a hard worker. 262 00:30:54,000 --> 00:31:00,000 So full time, I am going to pay you $100 a week. I am a giver. 263 00:31:00,000 --> 00:31:03,000 $100 a week. 264 00:31:03,000 --> 00:31:08,000 So you start working for me and after a year I call you in for your performance review. 265 00:31:08,000 --> 00:31:11,000 You are doing damn good. I am impressed by you. 266 00:31:11,000 --> 00:31:14,000 By golly, I want to keep you. 267 00:31:14,000 --> 00:31:20,000 Inflation last year was 2%. I am going to give you a 2% increase in your wage. 268 00:31:20,000 --> 00:31:25,000 $102 you will be making out. Now get back to work. 269 00:31:25,000 --> 00:31:33,000 So you come in the next year for your annual and I say, well, you are still doing great for us. 270 00:31:33,000 --> 00:31:40,000 I see that inflation last year was 4%. So I am going to give you a 4% increase in your wage. 271 00:31:40,000 --> 00:31:43,000 Now get your ass back to work. 272 00:31:43,000 --> 00:31:46,000 Third year you come in and I do the same thing. 273 00:31:46,000 --> 00:31:53,000 Well, still doing great. Inflation last year was 6%. So I am going to give you a 6% raise. 274 00:31:53,000 --> 00:32:00,000 And at this point you say, okay. 275 00:32:00,000 --> 00:32:05,000 But the next year you come in and I say, well, it looks like inflation is 8% this year. 276 00:32:05,000 --> 00:32:09,000 So I am going to give you an 8% increase. And you say, stop right there fat boy. 277 00:32:09,000 --> 00:32:12,000 No more of this bullshit. 278 00:32:12,000 --> 00:32:14,000 What is wrong with what I am doing? 279 00:32:14,000 --> 00:32:17,000 You are just keeping it consistent with the rate of inflation. 280 00:32:17,000 --> 00:32:19,000 What already happened? 281 00:32:19,000 --> 00:32:27,000 You see, you have lost money because it already had 6%. 282 00:32:27,000 --> 00:32:32,000 It already had the 4%. You are already paying those through the year. 283 00:32:32,000 --> 00:32:36,000 And then I give you 4% raise at the end of the year. 284 00:32:36,000 --> 00:32:47,000 You say, I want wealth 2, 4, 6, no 8. I want 10% because that is what I expect inflation to be eroding my purchasing power over the next year. 285 00:32:47,000 --> 00:32:49,000 Do you understand how it works? 286 00:32:49,000 --> 00:32:55,000 Expectation. It does not matter what already happened. It is what we expect to happen. 287 00:32:55,000 --> 00:33:02,000 I am a loan officer and I decide that I am going to give you, madam, a car loan at 5%. 288 00:33:02,000 --> 00:33:07,000 But inflation is going to be 7% over the life of that loan. 289 00:33:07,000 --> 00:33:19,000 I am not going to do it 5%. I am going to do it 7% because I expect the purchasing power of that money I lent you when I get it back to have been eroded at 7% per year. 290 00:33:19,000 --> 00:33:30,000 That is why markets only price money and capital on expected inflation premium, not on the actual inflation premium. 291 00:33:30,000 --> 00:33:36,000 And that is what the pain in the ass is for the Federal Reserve. 292 00:33:36,000 --> 00:33:41,000 What happens is that, well, let me give you an example. 293 00:33:41,000 --> 00:33:44,000 I will take you a little through the history of it. 294 00:33:44,000 --> 00:33:51,000 I usually do this a little later in the course, but I might as well do it now. 295 00:33:51,000 --> 00:33:59,000 This happened long before, this happened before probably even your parents were born. 296 00:33:59,000 --> 00:34:04,000 But now we understand it better now. 297 00:34:04,000 --> 00:34:13,000 Back in the 1950s we had a very solid growth. It was not impressive, but it was a solid growth. 298 00:34:13,000 --> 00:34:26,000 And we had, we had, by the end of the Eisenhower administration we had balanced the budget. 299 00:34:26,000 --> 00:34:30,000 Eisenhower was kind of the old time moderate conservative. 300 00:34:30,000 --> 00:34:41,000 He had no use for tax cuts. He had done one in 1954 when he first started, but he did not like the tax cuts that the Republicans were screaming about. 301 00:34:41,000 --> 00:34:46,000 He was not really big on social programs like the liberals were screaming about. 302 00:34:46,000 --> 00:34:53,000 But he did a few things, but he kept the economy on a steady course. 303 00:34:53,000 --> 00:35:01,000 Well, he retired at the end of his second term. Well, there were term limits. 304 00:35:01,000 --> 00:35:12,000 The presidential election pitted his vice president, Richard Milhouse Nixon, a hard right conservative, 305 00:35:12,000 --> 00:35:25,000 against this brash World War II officer hero, East Coast liberal, first Irish Catholic who would try to get the presidency, 306 00:35:25,000 --> 00:35:39,000 the name of John F. Kennedy. And it turned out to be sort of a fiasco for poor Nixon because the first live TV debate was grim. 307 00:35:39,000 --> 00:35:49,000 Because John Kennedy was very much aware of the media. He hung out with all these entertainers like Sinatra. 308 00:35:49,000 --> 00:35:58,000 There were even rumors of this affair he was having with this model named Norma Jean, actress. 309 00:35:58,000 --> 00:36:04,000 Her stage name was Marilyn something. I can't remember. 310 00:36:04,000 --> 00:36:11,000 And he was brash. He loved those lights. Now, this was back in the days of black and white where the lights were like stadium lights. 311 00:36:11,000 --> 00:36:17,000 That was all they had to use. And poor old Nixon, he was hunched over with a five o'clock shadow. 312 00:36:17,000 --> 00:36:24,000 He looked like a ghoul. There was Kennedy just loving the lights. And so he came to be president. 313 00:36:24,000 --> 00:36:36,000 And he started pushing different things, social programs. He worked. He was trying to get something called a Civil Rights Act passed. 314 00:36:36,000 --> 00:36:45,000 And he was also sending some advisors to this backwater patch of crap in the middle of nowhere called Vietnam. 315 00:36:45,000 --> 00:36:52,000 Now, understand that Kennedy hated communists like no one. He saw the communist threat as being a domino. 316 00:36:52,000 --> 00:36:59,000 One country falls and then it will just cause a cascade across Asia. Okay, spent a lot of money. 317 00:36:59,000 --> 00:37:07,000 He had a good tax base and all that. But the problem was that Jack was ambitious. 318 00:37:07,000 --> 00:37:17,000 But they called his reign Camelot. His wife was just awesome. She knew all. 319 00:37:17,000 --> 00:37:24,000 She even took the nation on a live tour of the White House that she had redone with Parisian stuff. 320 00:37:24,000 --> 00:37:33,000 She was quite the consummate first lady. And all Camelot ended in Dallas in November of 1963. 321 00:37:33,000 --> 00:37:40,000 And Jack Kennedy's vice president took over. His name was Lyndon Johnson. 322 00:37:40,000 --> 00:37:48,000 Lyndon Johnson was an old blue dog Democrat. He probably still had a white sheet hanging in his closet and all that kind of stuff. 323 00:37:48,000 --> 00:37:55,000 But he was vicious. He was a son of a bitch. He always had been. Hell, he was from Texas. 324 00:37:55,000 --> 00:38:01,000 There's even a famous story about him which has some relevance to what I'm about to say. 325 00:38:01,000 --> 00:38:09,000 But back when he was a senator, he had a couple of opponents that tried to come up against him to take his Senate seat. 326 00:38:09,000 --> 00:38:22,000 And the story goes that he told his campaign manager, I think, I can't remember who his opponent was. 327 00:38:22,000 --> 00:38:32,000 But Lyndon Johnson told his campaign manager, I want you to start a rumor that my opponent is a pig fucker. 328 00:38:32,000 --> 00:38:40,000 So, Lyndon, he ain't no pig fucker. I'm his wife, the little old junkie. So I said, shut up. I told you to tell people that. 329 00:38:40,000 --> 00:38:49,000 Because I don't want him living through this campaign without having to deny that he's a pig fucker. 330 00:38:49,000 --> 00:38:57,000 That was how vicious he was. So when he came into office, of course, I was in this. This was when I was a child. 331 00:38:57,000 --> 00:39:04,000 When Kennedy was killed, all those dancing in the street by all the conservatives in the right-wing nutcases. 332 00:39:04,000 --> 00:39:11,000 Thank God that liberal Catholic is dead. We can get back to Johnson. He's a blue dog Democrat from the South. 333 00:39:11,000 --> 00:39:15,000 He'll get things right. Well, they were wrong. 334 00:39:15,000 --> 00:39:20,000 Kennedy had wanted to get the Civil Rights Act passed. 335 00:39:20,000 --> 00:39:29,000 So, well, his Johnson's cohorts in Congress thought that's over. Johnson said, no, we're going to get it passed. 336 00:39:29,000 --> 00:39:35,000 Well, why? You don't believe in it. Because Jack wanted it, and you're going to do it. 337 00:39:35,000 --> 00:39:40,000 And all these blue dog Democrats, he took them into his White House, closed the doors. 338 00:39:40,000 --> 00:39:49,000 And each one of them, he explained to them exactly why they were going to pass it, because he reminded them of what he could do to them. 339 00:39:49,000 --> 00:39:57,000 Well, that was, and then Jack wanted all these social programs. And Jack wanted Vietnam solved. 340 00:39:57,000 --> 00:40:07,000 So we started pouring money into the projects. We poured money into welfare, food stamps, the whole nine yards. 341 00:40:07,000 --> 00:40:14,000 And we began to bomb the hell out of that piece of nowhere in Southeast Asia. 342 00:40:14,000 --> 00:40:23,000 All this cost money. And sooner or later, it got to the point where we had to start printing money to get all that done. 343 00:40:23,000 --> 00:40:28,000 Printing money. 344 00:40:28,000 --> 00:40:35,000 Well, you see, when you print money, the supply of money goes up, so the price of money goes down. 345 00:40:35,000 --> 00:40:47,000 So the real interest rate, short term, went down. 346 00:40:47,000 --> 00:40:58,000 The expected inflation premium didn't do anything. So the risk-free rate went down. 347 00:40:58,000 --> 00:41:05,000 And every time we needed more money, we'd print it and we'd keep interest rates low, so the business activity would keep going up and up. 348 00:41:05,000 --> 00:41:10,000 It was just a grand old time. 349 00:41:10,000 --> 00:41:14,000 Vietnam turned into an ugly affair. It got really bad. 350 00:41:14,000 --> 00:41:22,000 But Johnson didn't run for office in 68, so Nixon finally got his chance to be the president. 351 00:41:22,000 --> 00:41:32,000 Make no mistake about it, Nixon was a right-wing conservative, hard conservative, harder than most conservatives of that era. 352 00:41:32,000 --> 00:41:37,000 He was more along the lines of a guy named Barry Goldwater. 353 00:41:37,000 --> 00:41:47,000 But even Nixon had his progressiveness, and he was willing to see money being printed to keep the economy going. 354 00:41:47,000 --> 00:41:51,000 And he was willing to print money for other things, too. 355 00:41:51,000 --> 00:42:00,000 Well, the real problem came in what Nixon resigned in 74, I think it was. 356 00:42:00,000 --> 00:42:11,000 But before he resigned, back when he was still president, there was this brouhaha on the other side of the world in the Middle East. 357 00:42:11,000 --> 00:42:23,000 We had established a state called Israel, a place, a haven for the Jews who had come out of the Holocaust and was also being filled by Ashkenazi Jews out of Europe. 358 00:42:23,000 --> 00:42:30,000 And the Arabs hated this. And they had tried to destroy Israel a couple of times, and it didn't work. 359 00:42:30,000 --> 00:42:39,000 So in 73, they decided they were going to put all of their armies together and they were going to drive the state of Israel into the sea. 360 00:42:39,000 --> 00:42:44,000 Well, unfortunately, they got their asses kicked in about three days. 361 00:42:44,000 --> 00:42:49,000 And the Arabs suddenly said to them, now, let's see, how is this working? 362 00:42:49,000 --> 00:42:56,000 How can this tiny little state kick our ass? Oh, it's the United States pouring money into them. 363 00:42:56,000 --> 00:43:06,000 So what the Arabs did in the oil producing and exporting countries, they said, you've got a choice. 364 00:43:06,000 --> 00:43:12,000 And you have made that choice. So here's what we're going to do to the oil. 365 00:43:12,000 --> 00:43:17,000 We're going to turn it off. We're going to put an oil embargo on you. 366 00:43:17,000 --> 00:43:26,000 And so oil prices shot up. Gasoline prices went through the roof. There were lines literally miles long. 367 00:43:26,000 --> 00:43:34,000 I remember them very well, going clear out onto interstate highways and all of this kind of stuff. 368 00:43:34,000 --> 00:43:50,000 And so in order for people to be able to deal with this price shock, the Fed printed money, lots and lots of money. 369 00:43:50,000 --> 00:43:57,000 So that you were bitch, bitch, bitch, bitch, bitch about the oil prices. Here's extra money. You stop bitching. 370 00:43:57,000 --> 00:44:13,000 Okay. Printing money. Well, that, of course, there was a problem starting to seep in because the expected inflation premium was just starting to go up. 371 00:44:13,000 --> 00:44:20,000 And I'll put it over here. But what the Fed did was printing all that money, dropped it. 372 00:44:20,000 --> 00:44:27,000 So the risk-free rate continued down because the balance of the two was still in favor of the supply of money going up. 373 00:44:27,000 --> 00:44:33,000 So the real interest rate going down. Follow with me. It's getting more relevant as we go along here. 374 00:44:33,000 --> 00:44:44,000 Well, Nixon resigned and his vice president, Gerald Ford, moderate conservative, he was characterized as kind of a goofy guy. 375 00:44:44,000 --> 00:44:50,000 He was very tall and he'd crack his head on airplane door ceilings and things like that. 376 00:44:50,000 --> 00:44:54,000 But he understood that inflation was getting to be a problem. 377 00:44:54,000 --> 00:45:07,000 But it was more of a problem than you would want to imagine because when expected inflation began to embed, 378 00:45:07,000 --> 00:45:17,000 the Fed just printed more money to keep interest rates low. That balance up there on that top equation. 379 00:45:17,000 --> 00:45:28,000 Gerald Ford was not a stupid man, but he thought that he could do some kind of a slogan to get people to stop raising prices, 380 00:45:28,000 --> 00:45:33,000 to get companies to stop raising prices, to get unions to stop demanding wage increases. 381 00:45:33,000 --> 00:45:39,000 So his program was called Whip Inflation Now. When? 382 00:45:39,000 --> 00:45:43,000 Well, of course, a slogan isn't going to solve the problem. 383 00:45:43,000 --> 00:45:50,000 So as expected inflation premium began to embed more, even more, 384 00:45:50,000 --> 00:46:03,000 the Fed was correcting the risk free rate by just printing gobs more money to keep the interest rates low. 385 00:46:03,000 --> 00:46:11,000 But it was getting harder because each round of the printing of money embedded expected inflation further. 386 00:46:11,000 --> 00:46:16,000 So there was less and less effect from each printing of money. 387 00:46:16,000 --> 00:46:25,000 Ford was defeated in 1976 at the election by a peanut farmer from Georgia named Jimmy Carter. 388 00:46:25,000 --> 00:46:31,000 It's important to note that Jimmy Carter was also a nuclear physicist. 389 00:46:31,000 --> 00:46:34,000 He understood what was actually happening. 390 00:46:34,000 --> 00:46:41,000 But he also was a very, he didn't want to do what had to be done at first. 391 00:46:41,000 --> 00:46:53,000 He did his own slogan. He said, I believe that this fight against inflation is the moral equivalent of war. 392 00:46:53,000 --> 00:46:59,000 Now, if you work out moral equivalent of war, that has the acronym MEOW. 393 00:46:59,000 --> 00:47:06,000 Most unfortunate, they have those marketing people in the White House. 394 00:47:06,000 --> 00:47:13,000 And so the inflation rolled. Expected inflation became more embedded. 395 00:47:13,000 --> 00:47:20,000 And the Fed was trying to print money, but interest rates were starting to slide upward, 396 00:47:20,000 --> 00:47:27,000 stagnating the economy with inflation. So you got stagflation. 397 00:47:27,000 --> 00:47:31,000 Carter actually was not stupid. He was a physicist for God's sake. 398 00:47:31,000 --> 00:47:34,000 He understood the economics. He knew what was going on. 399 00:47:34,000 --> 00:47:45,000 So in 1979, he appointed a new chairman of the Federal Reserve, who just passed on recently, of all things. 400 00:47:45,000 --> 00:47:58,000 His name was Paul Volcker. Volcker was six feet some inches tall, 250 pounds of I don't give a shit. 401 00:47:58,000 --> 00:48:01,000 He would literally, in that time, he smoked big cigars. 402 00:48:01,000 --> 00:48:04,000 And if he didn't like you, he'd blow the smoke right in your face. 403 00:48:04,000 --> 00:48:10,000 And he walked in there and he said, we are going to clamp down on the money supply. 404 00:48:10,000 --> 00:48:14,000 We're going to crush it. We're going to deal with this. 405 00:48:14,000 --> 00:48:23,000 Now, of course, the markets, yeah, yeah, sure, sure. Expected inflation skyrocketing. 406 00:48:23,000 --> 00:48:30,000 But Volcker was actually cutting the money supply. 407 00:48:30,000 --> 00:48:35,000 Markets didn't believe him. The markets did not believe him. 408 00:48:35,000 --> 00:48:41,000 So they just kept embedding progressively higher expected inflation premium into interest rates, 409 00:48:41,000 --> 00:48:47,000 which were already starting to skyrocket because the supply of money really was being cut. 410 00:48:47,000 --> 00:48:54,000 And so we drifted on the verge of a terrible recession going into the 1980 election. 411 00:48:54,000 --> 00:48:59,000 And Carter looked like an idiot. He looked like a fool. 412 00:48:59,000 --> 00:49:04,000 You made it worse. Now we have these terribly high interest rates. 413 00:49:04,000 --> 00:49:06,000 No one can buy a home. 414 00:49:06,000 --> 00:49:11,000 Corporations are issuing bonds with coupons of 20 percent, for God's sake. 415 00:49:11,000 --> 00:49:15,000 And inflation is rolling. Stagflation is everywhere. 416 00:49:15,000 --> 00:49:23,000 So his opponent won. That opponent's name was Ronald Reagan, former governor of California 417 00:49:23,000 --> 00:49:33,000 and a former movie actor and famous voice for cigarette advertisements. 418 00:49:33,000 --> 00:49:39,000 Reagan won. But Volcker was in effect. And he was not going to let up. 419 00:49:39,000 --> 00:49:46,000 It took probably about two years before Volcker, they answered, 420 00:49:46,000 --> 00:49:51,000 Volcker was simply asking them the question, who's your daddy? 421 00:49:51,000 --> 00:50:02,000 And finally the markets, and finally the expected inflation premium began to seep out in 81 and 82. 422 00:50:02,000 --> 00:50:10,000 The economy began to pick up with a radical tax act that was passed, the Tax Reform Act of 1981. 423 00:50:10,000 --> 00:50:18,000 And after a few years, finally the expected inflation premium began to give way. 424 00:50:18,000 --> 00:50:26,000 And so over a period of the next few years, Volcker began to let up on the money supply a little bit 425 00:50:26,000 --> 00:50:32,000 so that the real interest rate would come down as expected inflation premium was coming down. 426 00:50:32,000 --> 00:50:42,000 That's what happens when you play around with the risk-free rate. It is a bitch. 427 00:50:42,000 --> 00:50:46,000 And getting rid of that expected inflation premium, that's hard. 428 00:50:46,000 --> 00:50:54,000 So let's reel forward to the second decade of the 21st century. 429 00:50:54,000 --> 00:51:06,000 Specifically, we had a major crisis in 2008, which took until 2011, 2012, to fix with some big money. 430 00:51:06,000 --> 00:51:10,000 But the Federal Reserve was holding monetary policy fairly tight. 431 00:51:10,000 --> 00:51:15,000 Inflation was staying under control. Real interest rate was staying under control. 432 00:51:15,000 --> 00:51:20,000 So interest rates in general were relatively stable. 433 00:51:20,000 --> 00:51:23,000 And then problems started. 434 00:51:23,000 --> 00:51:35,000 We enacted the former President Barack Obama was replaced by President Trump in the 2016 election. 435 00:51:35,000 --> 00:51:42,000 In 2017, a major tax act, the deepest, strongest tax act in history was passed, 436 00:51:42,000 --> 00:51:48,000 cutting the corporate tax rate down to 21% from the top marginal that was 39%. 437 00:51:48,000 --> 00:51:50,000 And we went on from there. 438 00:51:50,000 --> 00:51:58,000 So that was going to cause budget deficits, therefore larger and larger budget deficits. 439 00:51:58,000 --> 00:52:04,000 Therefore, we would have to print some more money to try to monetize the shock of those deficits. 440 00:52:04,000 --> 00:52:09,000 The Treasury was selling T-bills and Treasury notes and Treasury bonds. 441 00:52:09,000 --> 00:52:12,000 So, of course, we were borrowing money. 442 00:52:12,000 --> 00:52:17,000 And when you borrow money like that, it's going to cause interest rates to go up. 443 00:52:17,000 --> 00:52:24,000 So the Fed countered that by printing money, and the Fed went to the Treasury auctions and bought the bills itself. 444 00:52:24,000 --> 00:52:26,000 That was the start of the trouble. 445 00:52:26,000 --> 00:52:34,000 And then we got into a mild recession in 2019, 2020. 446 00:52:34,000 --> 00:52:42,000 Now, the Federal Reserve had been threatened by President Trump that he was going to fire the Board of Governors, 447 00:52:42,000 --> 00:52:47,000 which most people say he can't do that, but it scared them enough. 448 00:52:47,000 --> 00:52:56,000 They just started printing money just to keep that recession from getting too interfering too much with the 2020 election. 449 00:52:56,000 --> 00:53:08,000 Then we had COVID, and the Fed printed money hand over fricking fist, making these PPP loans, 450 00:53:08,000 --> 00:53:12,000 sending out COVID checks to everyone and his mother. 451 00:53:12,000 --> 00:53:15,000 And that, of course, ballooned the deficits. 452 00:53:15,000 --> 00:53:20,000 And in order to keep interest rates under control, the Fed printed money. 453 00:53:20,000 --> 00:53:23,000 And hence, guess what happened? 454 00:53:23,000 --> 00:53:28,000 We had that inflation that you saw in the last couple of years. 455 00:53:28,000 --> 00:53:36,000 Well, fortunately, now the Fed this time said, we know where this is going, and it's not a good story. 456 00:53:36,000 --> 00:53:44,000 So they started cracking down on interest rates, cracking down on the money supply, contracted interest rates, 457 00:53:44,000 --> 00:53:50,000 popped through the roof, and of course, we had already gotten an expected inflation premium starting to embed. 458 00:53:50,000 --> 00:53:58,000 And they got in front of it a lot faster this time than they did in the 1960s, 1970s cycle. 459 00:53:58,000 --> 00:54:03,000 And so we got, we're able to get out of it a little faster now too. 460 00:54:03,000 --> 00:54:07,000 So there you are. That's where we are at this point in time. 461 00:54:07,000 --> 00:54:16,000 So this is why this is all relevant to you is so that you understand what the dynamics are of interest rates. 462 00:54:16,000 --> 00:54:27,000 Before I even talk about other parts of interest rates, this risk-free rate is at the core of what we have to use in finance 463 00:54:27,000 --> 00:54:32,000 for our understanding of where interest rates are going to go. 464 00:54:32,000 --> 00:54:39,000 Because as interest rates go up, the present value of future expected cash flows goes down. 465 00:54:39,000 --> 00:54:44,000 Make sure you know that because I'm going to ask that on a quiz and on exams. 466 00:54:44,000 --> 00:54:49,000 When interest rates go up, you try it yourself with those spreadsheets. 467 00:54:49,000 --> 00:54:57,000 Jack up the interest rate. What happens to the present value of future expected cash flows? 468 00:54:57,000 --> 00:55:05,000 So that's an absolutely critical understanding that when we've, yeah. 469 00:55:05,000 --> 00:55:13,000 As interest rates go up, the present value of future expected cash flows goes down. 470 00:55:13,000 --> 00:55:19,000 When interest rates go up, the present value of future expected cash flows goes down. 471 00:55:19,000 --> 00:55:24,000 It's a critical inverse relationship. 472 00:55:24,000 --> 00:55:32,000 I'm allergic to macroeconomics. 473 00:55:32,000 --> 00:55:39,000 So let's do this. Let me show you this. 474 00:55:39,000 --> 00:55:49,000 And I'm taking you in deep. Deep enough that you, in one lecture, will know more than 99.5% of the ho handles out there in this country. 475 00:55:49,000 --> 00:55:52,000 You know that it's not mysterious. It's technical. 476 00:55:52,000 --> 00:56:04,000 And it is the intersection of the physics of money with political will and political challenges. 477 00:56:04,000 --> 00:56:15,000 So here we go. Suppose that you have projects. 478 00:56:15,000 --> 00:56:20,000 And you have the return on investment to these projects, ROI. 479 00:56:20,000 --> 00:56:25,000 Projects A, B, and C. 480 00:56:25,000 --> 00:56:34,000 Now the ROI of A is, let's say, 8%. 481 00:56:34,000 --> 00:56:38,000 The ROI of B is 12%. 482 00:56:38,000 --> 00:56:46,000 The ROI of C is 15%. 483 00:56:46,000 --> 00:56:49,000 You follow? 484 00:56:49,000 --> 00:57:01,000 Now suppose that the prevailing interest rate environment is at this risk level for money for these projects. 485 00:57:01,000 --> 00:57:05,000 Let's say it's 6%. 486 00:57:05,000 --> 00:57:10,000 Well, A is 8%, so yes. 487 00:57:10,000 --> 00:57:12,000 B is 12%, oh yeah. 488 00:57:12,000 --> 00:57:14,000 And 15% for C, yes. 489 00:57:14,000 --> 00:57:16,000 We're going to take on all those projects. 490 00:57:16,000 --> 00:57:23,000 We're going to accept all of them because they return more than the cost of the capital to cause them. 491 00:57:23,000 --> 00:57:32,000 Now is what happens if the interest rates go to 10%. 492 00:57:32,000 --> 00:57:45,000 Well, we still take C, yeah, 15, 12, yeah, we cost the capital, but A is gone. 493 00:57:45,000 --> 00:57:53,000 Suppose interest rates now go to 14%. 494 00:57:53,000 --> 00:58:04,000 Well, C is still there, but now B is gone, and obviously A is gone for good. 495 00:58:04,000 --> 00:58:14,000 Do you see that driving interest rates upward, the cost of capital increases, and it makes fewer and fewer projects doable, profitable? 496 00:58:14,000 --> 00:58:17,000 That's the important point here. 497 00:58:17,000 --> 00:58:20,000 And there's even another nasty effect of this. 498 00:58:20,000 --> 00:58:29,000 First of all, those projects aren't taken on, so obviously employment created by those projects won't happen. 499 00:58:29,000 --> 00:58:33,000 The economy slows down and all that good stuff. 500 00:58:33,000 --> 00:58:41,000 So you're slowing down the economy because the investments aren't as thick and rich. 501 00:58:41,000 --> 00:58:50,000 But there's another nasty effect. If you look at those ROIs, remember that risk and return are directly related. 502 00:58:50,000 --> 00:58:58,000 Do you see how as interest rates are rising, this company is being backed into a corner of risky projects? 503 00:58:58,000 --> 00:59:03,000 Those are the only ones that work. Those are the only ones that are profitable. 504 00:59:03,000 --> 00:59:17,000 So you're pushing companies to get rid of all the nice, steady, low-risk projects and go after only the projects that are risky. 505 00:59:17,000 --> 00:59:23,000 Hence, more bankruptcies because risk sometimes means you get your butt kicked. 506 00:59:23,000 --> 00:59:26,000 And that's what happened here. That's what happens every time. 507 00:59:26,000 --> 00:59:31,000 That's why high interest rates are killers to an economy. 508 00:59:31,000 --> 00:59:39,000 We want to keep interest rates in some stability so that we have that ability to forecast. 509 00:59:39,000 --> 00:59:47,000 Look, if I see interest rates right now at 10%, but I am scared to death that they are going to rise, 510 00:59:47,000 --> 00:59:58,000 I'm not even going to look at Project B because the expectation is that I will not ultimately clear my ROI hurdle with the cost of capital. 511 00:59:58,000 --> 01:00:08,000 You follow with me? It's the expectation. So that's why we can't have instability in the political monetary world. 512 01:00:08,000 --> 01:00:20,000 We need companies to have a certainty so that they can reach forward and know that a 12% project will be profitable. 513 01:00:20,000 --> 01:00:26,000 So that they know that an 8% project will be profitable if interest rates are 6%. 514 01:00:26,000 --> 01:00:32,000 That's where expectations drive us in finance. We can't look at history. 515 01:00:32,000 --> 01:00:38,000 It tells us nothing about what is going to happen in front of us. 516 01:00:38,000 --> 01:00:44,000 Okay, so anyway, you understand where I'm going with all of this. 517 01:00:44,000 --> 01:00:55,000 And this takes you into the realm again, shaping you so that you understand that these aren't magical and mysterious and conspiracy and darkness. 518 01:00:55,000 --> 01:01:01,000 It's all the mathematics and the dynamics and expectations. 519 01:01:01,000 --> 01:01:09,000 And that is one of the things about becoming a world leader or a leader of industry, as you will. 520 01:01:09,000 --> 01:01:14,000 It is that we have to be the adults at the table. 521 01:01:14,000 --> 01:01:19,000 And we have to give the people their bread and circuses and keep them shut the hell up 522 01:01:19,000 --> 01:01:25,000 while we manage the affairs of the economy, the state, and the corporate world. 523 01:01:25,000 --> 01:01:29,000 That sounds harsh, but that's how it is. Now, what else is in here? 524 01:01:29,000 --> 01:01:37,000 There is this... well, if all that matters is this substrate, then all interest rates would be R sub F. 525 01:01:37,000 --> 01:01:51,000 But they are not, because on top of R sub F is this pack of risk premiums. 526 01:01:51,000 --> 01:01:57,000 Premiums in modern language, since we don't use Latin. Risk premiums. 527 01:01:57,000 --> 01:02:06,000 The risk premium. This is what causes interest rates to be different from one another. 528 01:02:06,000 --> 01:02:16,000 It's because each one has a balance of these in it. 529 01:02:16,000 --> 01:02:22,000 Now, I'm going to put these up here. 530 01:02:22,000 --> 01:02:28,000 The first one is the default premium. 531 01:02:28,000 --> 01:02:37,000 You have to add a little bit to every loan in case the borrower defaults. 532 01:02:37,000 --> 01:02:48,000 Now, let's say that you have a mortgage loan, a home loan that carries a mortgage attachment to it. 533 01:02:48,000 --> 01:02:58,000 That would have a low default premium, because even if you default, the bank has an asset recourse. 534 01:02:58,000 --> 01:03:10,000 So the default premium would be pretty low on a home loan, simply because it's backed by an asset. 535 01:03:10,000 --> 01:03:16,000 However, a credit card... you know why those rates are so stupid high? 536 01:03:16,000 --> 01:03:20,000 There's nothing backing them. There's nothing at all. 537 01:03:20,000 --> 01:03:29,000 So they have to just rely on you paying your credit card bill every month. Period. 538 01:03:29,000 --> 01:03:33,000 So that's going to be a high default premium. 539 01:03:33,000 --> 01:03:43,000 That's why a credit card interest rate is higher than a home mortgage loan interest rate. 540 01:03:43,000 --> 01:03:52,000 The next one is the maturity premium. 541 01:03:52,000 --> 01:04:02,000 This one is a volatility thing. 542 01:04:02,000 --> 01:04:10,000 I'm a banker, and you succumb to me for a home loan. 543 01:04:10,000 --> 01:04:14,000 Okay, we're going to charge you 6%. 544 01:04:14,000 --> 01:04:25,000 What happens if in, let's say, five years, it's a 30-year loan, five years, interest rates fall to, on mortgages, fall to 3%? 545 01:04:25,000 --> 01:04:32,000 What would you do with your home loan? 546 01:04:32,000 --> 01:04:37,000 No, you'd refinance it at 3%. 547 01:04:37,000 --> 01:04:40,000 Refi. 548 01:04:40,000 --> 01:04:48,000 And I'm saying, well, you son of a bitch, I was expecting to get 6% for 30 years, and now I'm going to get only 3%. 549 01:04:48,000 --> 01:04:53,000 So I'm going to charge you a little scratch for that possibility that you could screw me. 550 01:04:53,000 --> 01:04:55,000 Sounds good? 551 01:04:55,000 --> 01:04:57,000 Well, what about the other way? 552 01:04:57,000 --> 01:05:05,000 Let's say that instead you got a 6% loan, and mortgage interest rates go up to 12%. 553 01:05:05,000 --> 01:05:14,000 Well, you see, the average homeowner sells the home in about seven years and then gets a new loan. 554 01:05:14,000 --> 01:05:22,000 But if interest rates go clear up to 12%, and you've got a 6% loan, you're not going to flip your house. 555 01:05:22,000 --> 01:05:32,000 Even though now you have eight kids, your brother-in-law lives in the garage with his girlfriend, 556 01:05:32,000 --> 01:05:40,000 and you've got some guy you don't even know who seems to be hanging around in the basement too much. 557 01:05:40,000 --> 01:05:52,000 You've got three dogs, you used to have one dog, now you have three dogs that have four legs among the three of them. 558 01:05:52,000 --> 01:05:56,000 But you've got a 6% loan, and if you sell that house and get another house, you're going to have to get 12%. 559 01:05:56,000 --> 01:05:58,000 No, I'd love to have you do that. 560 01:05:58,000 --> 01:06:02,000 If I get your money back, I'm going to lend it out 12%, but you say, oh, I know you don't, fat boy. 561 01:06:02,000 --> 01:06:04,000 I'm going to stay here. 562 01:06:04,000 --> 01:06:11,000 I'm just going to build another garage, a place where the dogs can stay and not have to run around hobbling. 563 01:06:11,000 --> 01:06:15,000 Basically, the bravest dogs are not running around. 564 01:06:15,000 --> 01:06:17,000 Well, they were. 565 01:06:17,000 --> 01:06:22,000 Found some sticks that they could hold on to. 566 01:06:22,000 --> 01:06:27,000 But you understand what I'm saying here is that no matter which way interest rates move, I'm screwed. 567 01:06:27,000 --> 01:06:33,000 So if interest rates show volatility, I'm going to charge a larger maturity premium. 568 01:06:33,000 --> 01:06:44,000 And another nasty fact, the farther out in time you go, the more likely an adverse event to me is going to happen. 569 01:06:44,000 --> 01:06:48,000 Two years, three years, interest rates aren't going to move that much. 570 01:06:48,000 --> 01:06:50,000 But in 30 years, yeah. 571 01:06:50,000 --> 01:07:03,000 So the longer, that's why we call it a maturity premium, is because the longer the loan is, the more likely an adverse movement of interest rates is going to occur. 572 01:07:03,000 --> 01:07:06,000 It is actually a principle of physics, and you see it all the time. 573 01:07:06,000 --> 01:07:09,000 I had a car. 574 01:07:09,000 --> 01:07:14,000 The tailpipe spewed out black smoke. 575 01:07:14,000 --> 01:07:17,000 When it came out of the tailpipe, it was just like that. 576 01:07:17,000 --> 01:07:26,000 But as it went down the road, everywhere, it backfired, too. 577 01:07:26,000 --> 01:07:31,000 My daughter didn't want me to drop her off at school because she'd get out of the car and I'd make a backfire and she was humiliated. 578 01:07:31,000 --> 01:07:36,000 Bam! Yay, all the other kids would say. 579 01:07:36,000 --> 01:07:40,000 Anyway, you understand that it's just a gas diffusion principle. 580 01:07:40,000 --> 01:07:48,000 As time goes on, the gas will diffuse, and that's what's happening with risk premium, the maturity premium. 581 01:07:48,000 --> 01:07:57,000 It is just simply the fact that as time goes on, there are more events that have some probability of happening. 582 01:07:57,000 --> 01:08:08,000 So in other words, a treasury bill, there's no default premium in government debt, but there is a maturity premium that gets bigger and bigger. 583 01:08:08,000 --> 01:08:18,000 So the maturity premium in a 30-year treasury bond would be much, much larger than the maturity premium in a five-year bond. 584 01:08:18,000 --> 01:08:24,000 And it would also have to do with how volatile we are perceiving future interest rates. 585 01:08:24,000 --> 01:08:28,000 If we don't think they're going to spread too much over time, the maturity premium would calm down. 586 01:08:28,000 --> 01:08:32,000 It would get bigger as time goes on, but it would do so at a slower rate. 587 01:08:32,000 --> 01:08:43,000 But if we are in a high-volatility interest rate environment looking forward, then that maturity premium is going to start out wide and is going to get like that. 588 01:08:43,000 --> 01:08:51,000 So that's the maturity premium. And then there's one last one called the illiquidity premium. 589 01:08:51,000 --> 01:08:55,000 I used to call it the liquidity premium. We used to call it the liquidity premium. 590 01:08:55,000 --> 01:09:03,000 It's just the fact that, and I think I already said this, loans like home loans. 591 01:09:03,000 --> 01:09:09,000 You go to your bank, you get a mortgage, a loan with a mortgage for a house. 592 01:09:09,000 --> 01:09:13,000 That bank doesn't keep that for more than a few hours usually. 593 01:09:13,000 --> 01:09:22,000 It takes the loans, bundles them up, and sells them to a secondary mortgage market like Ginnie Mae, Fannie Mae, Freddie Mac, something like that. 594 01:09:22,000 --> 01:09:30,000 So a CMO? Yeah. Yeah. Well, as a matter of fact, that's what backs those, is those giant packages of loans. 595 01:09:30,000 --> 01:09:37,000 So in other words, home loans have high liquidity. They're easy to dump within hours. 596 01:09:37,000 --> 01:09:42,000 But car loans, there's no such thing as that. They're stuck with them. 597 01:09:42,000 --> 01:09:51,000 If a bank wanted to get rid of its car loans, they'd have to sell them at pennies on the dollar. 598 01:09:51,000 --> 01:09:54,000 The same would be true for credit card debt, a lot of debt. 599 01:09:54,000 --> 01:10:00,000 You see, banks really aren't in the business of loans. 600 01:10:00,000 --> 01:10:04,000 It sounds, wait, wait, what do you mean by that? They are not. 601 01:10:04,000 --> 01:10:13,000 They're in the business of originating the loans, and then they get rid of them, and all they do is then service the loans. 602 01:10:13,000 --> 01:10:18,000 You say, oh, I sent my payment for my mortgage loan to my bank. 603 01:10:18,000 --> 01:10:22,000 Well, yeah, but all they do is keep a little bit of it for their processing fees, 604 01:10:22,000 --> 01:10:28,000 and then they send it on to the secondary mortgage market owner of the bond. 605 01:10:28,000 --> 01:10:38,000 So that's one of those things that's kind of a little bit odd, is to think about the bank not as a lender in the old fashioned sense. 606 01:10:38,000 --> 01:10:45,000 So the liquidity premium is there if a bank can't get rid of a loan easily. 607 01:10:45,000 --> 01:10:51,000 And it's worse, the harder it would be for them to dump the loan. 608 01:10:51,000 --> 01:11:19,000 I've given you enough. This is some good stuff to chew on. That's all I have for you today. I thank you.