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Alan Cring Productions in association with the Emergent Light Studio presents

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the Illinois State Collegiate Compendium, Academic Lectures in Business and Economics.

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This is Business Finance, FIL 240 for spring semester 2024.

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Today, bonds and yield curves.

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You will have a quiz at the end of the period.

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And we will go through one last example of the spreadsheet that I've been showing you

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as part of what I'm doing now.

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But starting it off, well let me put up the projector first here.

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This is not an easy day to characterize.

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Everything is down right now, but if you look at the percentages, they are just somewhat negative.

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It was trying to stay positive. The bulls were fighting early, but after the lunch hour,

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which was actually here an hour later, but it got grim.

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The bears finally have taken a little bit of control of it, but there's still not much of a negative sentiment.

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It's just down a little bit. The Dow down a quarter of a percent, and then the S&P 500 down

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somewhere about a third of a percent, but the Nasdaq is down just barely.

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It's been really volatile, and it's kind of difficult to say where it's going to go from here,

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but it's definitely not a day that's easy to explain, other than that there is good news and bad news

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both going on, but nothing is too dramatic on either front.

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Now I want to take you over here very quickly. The crude oil has been working its way upward.

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It seems to be on a roll ever since about midday. It's been trying to pull upward,

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and we're still within that trading band, 72 to 79, but it's kind of climbing up there a little bit

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close to the upper level of it. A little bit higher gas prices maybe, but right now the gas prices

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are kind of being driven more by supply and demand conditions out there in the pipelines

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and the trucks to the retail side. Hard to say, but gold is down, which is good news because

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that simply means that there's no panic and there's no buying gold because the economic end of times

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is coming. So that's good news right there. A 10-year bond has been climbing. Unfortunately,

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the yield is back up there again. It's gone up about four and a half basis points, so that would mean

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if the yield is rising, the price is falling, and that would mean that there is selling of the bonds,

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getting rid of the bonds, and there's also some getting rid of the stocks as well,

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but it's not going into gold or anything like that, so it's probably just parking to the sideline,

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money market stuff, just to see what's going to happen. And you had kind of an odd day over in Japan.

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Well, it wasn't terrible. It just walked up, and then it just kind of walked back down some of what it had

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gained, hardly anything for the day, and the London, it was just bad all day. It wasn't a horrible day, though.

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If you look at that percentage, it looks terrible when you see the red spark chart, but when you look at the

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percentage, that's hardly anything at all, 0.29%. So it's just one of those, a little bit on the grouchy,

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bearish side, but it's nothing dramatic. It's not like the end of the world is coming or anything like that,

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which is good news. Now, let me take you on a little bit of a journey here. Now, I'm going to, here's something.

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This is chapter seven, but I'm going to walk back into a little bit of chapters five and six,

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just to reinforce and to bring up some new things, and I'm also going to show you an improvement on that

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spreadsheet, one last improvement that will help you on the midterm exam. Also, as far as the current

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chapter, chapter seven is bonds. Now, as far as midterm is concerned, I will, on the midterm, I will do the

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qualitative, the terms and the concepts part of the bonds chapter, but the calculations part, I'll do those on

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Wednesday with you, and we'll do them in Excel, so it won't be horribly painful, but I will not ask the

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numerical questions about the bonds. In other words, calculating yields and prices and all that kind of

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stuff. I won't ask those on this midterm exam. They're fair game for the final, of course, but it's just a

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little too close. Doing that on Wednesday, and then next week is your midterm, that's a little close for,

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that's a little too close in time for you to actually master it. So, the qualitative stuff, names, terms, and

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all that, yeah, that's fair game, but not the math, math-y part of it. But, a couple of things, and this will

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sound like I'm going back and forth between a couple of subjects, but they are actually all tied together

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here, as I hope you'll see eventually, but as I told you earlier in the course, there are all these different

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words and terms that mean about the same thing. Interest rate, yield, return, they're all the same, they're all

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the same thing, they're a percentage, or a decimal if you do it with the math. But, so, return, yield, rate,

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about all about the same term, but we use a different one for each different subject. So, for example, when

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we're talking about stocks, holding a stock, we have one term called the holding period return.

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Otherwise known as the HPR. HPR. And, this is a fairly simple term. All you do is you take the ending value

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over the beginning value minus one. So, for example, you, sir, you put $100 into an account, and in a year

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it's worth 110. So, that would be an HPR of 110 over 100 minus one, or 10%. Now, you, on the other hand,

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madam, you put $100 in, and in six months you have $110. So, you have 110 over 100 minus one, so you have 10%.

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They look the same, but there's the problem. This holding period, holding period here was one year, the holding

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period here was six months. So, they're not the same units. That's what we have to do in finance, is convert

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all of them into a common base, what we call the annualized, or the annual. Now, this one is already an annual

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return. It's 10%. So, that is an annual return. That's desirable. That's what we want. But this one isn't an

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annual return. It's a half-year return. So, we would have to convert that into an annualized return. Well, you say,

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well, okay, that's easy enough to do, fat boy. Just take it times two, two semi. No, you can't do it that way.

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That's called the arithmetic way. But in the real world, we have to use the compounding way. What's called, in math,

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it's called the geometric approach. And that's a little bit more complicated. So, that's a holding period return.

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It's up there, the HPR. However, the annualized way to do it would be to take the ending period over the beginning

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period to the one over the number of years. I'm trying to write this large, and I'm not. I appreciate it. Minus one.

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That's the annualized way of doing it. And that is actually at the very top of your formulas sheet. So, you've got this,

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remember that financial analysis formula, formulas, that guy right there, it's at the top, one over the number of years.

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So, this one would be 110 over 100 to the one over one year minus one, which would, of course, be 10%.

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This one, however, would be 110 over 100 to the one over 0.5 year minus one. And I can't do that in my head.

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I'm not even going to try. Bear with me here a minute while I get this off the board here.

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And I'm going to pull up, I'll just use the TI calculator I've got here to do this and clear it.

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And so, I'll do one open parenthesis. Don't forget parentheses. They're very important here. 110 divided by 100.

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Now, for heaven's sakes, you probably already know this, but I'm emphasizing to the, now for this second one,

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I'm going to open parenthesis, one divided by 0.5, close the parenthesis.

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Notice how you have to trap that exponent in its own parentheses. Don't forget to do that.

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And also, don't forget to do what I forget to do. Don't forget to put that minus one. It has to be there.

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What comes out if you don't looks like a percentage, but it isn't. So, I warn you that that one can trick you.

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But if I do that in this case, let me see what that comes out to be. 0.21 percent. 21 percent.

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Notice that it isn't 2 times 10. The reason is that the compounding of the first amount,

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that extra earnings from that first amount, if you took it to a second, would cause you to have a greater return

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in the second period than in the first. So, that's why that has to be done.

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Now, it's not bad to do it. Let me show you. So, for example, we'll do one here.

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You're an investing genius. Yes, you are. You're certainly better than I am, considering how I've been doing lately.

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But let's try this one. You buy a stock for $58.35

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and sell it three years later for $70.84.

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Okay, now I'm going to show you the magic. First, I'm going to do it on the calculator, and then I'm going to show you what I've done in your spreadsheet that will make it a lot easier.

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Well, it would be the end, $70.84 over the beginning, $58.35.

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Now, you close that in parentheses, and you raise it to one over the number of years, minus one.

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It's not too bad.

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The only reason I would criticize this method is because you can make a mistake with a parenthesis.

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But if we watch what we're doing, it won't be anything terrible. Open parenthesis.

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$70.84 divided by $58.35, and then we close the parenthesis, and then we raise that.

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Open parenthesis, one divided by three, close the parenthesis, and this is where you make the mistake, where I make the mistake anyway, minus one.

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6.68% is your annualized return. That's an annualized return, an APR, 6.68% on your investment.

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This way, I can look at different investment holding periods, and the results all come out in the same units.

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So I could look at this one, compare it to one I'd held for five years or for two years, and the results are all, tell me, the same units of it.

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So I'm not measuring feet against meters and all that kind of stuff.

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Now, let me show you what I've done here.

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You're going to go in, you'll go in to your spreadsheets, to files, and you're going to go down here to the one that you've already downloaded,

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and you'll want to download this latest version.

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Where the hell is it? Oh, spreadsheets, duh, I've got to get the spreadsheets up.

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Spreadsheets. Try it again. There we go. Now, present values and future values, and I'm going to download this one.

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Download.

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Now, the first worksheet in here, is there some reason that didn't happen or did it actually happen?

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Downloads.

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Yeah, there it is. Okay, so I've got it. Oh, I see it. It opened it. Duh.

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Okay, now, the first sheet is the one that you recognize already, the one that I've shown you how to do.

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It's just a good, it's just one of those sheets that will save your bacon getting present values of annuities, future values of annuities, payments on loans, effective rates.

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It's a very nice tool. You'll probably want to keep it in your archives for the rest of your life, just as one of the pieces of memorabilia.

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However, I've added this one, annualizing. Now, I just did the first version of this, and I'll show you the second version where you can do days instead of years.

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But watch, again, we'll do the same thing we did, 5835 for the beginning, 5835, and then we'll do the second one, 7084.

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And this one is three years, and I'm going to show you how to do this trick so that you get your units.

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What's wrong? Oh, 5835. Well, yeah, I was going to say that's a damn good investment. 5835.

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Now, I did that just so you could see how easy it is to make a type of, there's your answer.

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And what I like about this is when you use the formula, you have to remember to put the last one on top and the first one on the bottom.

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Here, once you, you've got complete free reign over architecture in Excel, so I put them in the natural order.

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The first is on top, the second one is next, all that. You got your answer to one of these. Really easy.

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The real pain in the butt comes when you have days instead of years.

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And that's nothing, if you know the number of days.

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You bought a stock for $18.71 and sold it, let's say, 12 days later.

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For $19.41.

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That doesn't look like much of a return.

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But if I look at it on an annualized basis, I can do $18.71, and I'm using the days between column now, and in 12 days, and the ending value was $19.41.

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And I did that for 12 days, that's a hell of a return.

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That's what day traders play for, is just to have, make a few bucks or a few cents over and over and over again through a year, and those annualized yields chain together.

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That's the power of mutual funds too sometimes. If it just keeps reinvesting your dividends or selling stocks and then putting the money back into a new stock,

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you can have a hell of a chain of annualized returns that turn into an annual return.

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And that's, like I said, that's how day traders try to play it. They just win a little bit at a time, but in annualized terms, if you can keep doing that, it is appalling how much you can make off it.

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That's the way to do it in days. Now, what happens though, and I may put this in, I won't ask it on an exam.

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If you had something like, you bought a stock on 14 March 2021 for $26.15.

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And sold it on 17 September 2023 for $30.19.

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Now that's a little more of a problem because you need to get days or decimals of years. You can get the days is probably easier.

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There's a way in Excel and I haven't put it in here, and the reason being I won't ask this, but all you have to do, and this is just a nasty little stupid pet trick.

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I can go over here, Google, and like I said, you can do this right in Excel, but I'm not going to do it that way. I'm just giving you an illustration.

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Days between dates. I don't want it in Excel. It should give you a calculator for it.

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Date, duration, calculator, time and date. So you just give it, in this case, 14 March 2001. So that'd be March at once first, 03, 14th, 2021.

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And I said what? 14th of March 2021, and then you sell it on September the, what did I do there? September the 17th, thank you, 2023.

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2023, well, there we go, 2023. Calculate the duration. 187 days.

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Oh, geez, really? There's what I did. See, I was just, again, I'm just testing to make sure that you're doing okay here. 2023. Wow.

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I was going to say that's, oh, so it wasn't me. There. Now calculate the damn thing. 917. You saw that. I didn't, okay, anyway.

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917 days. So I know 917 days. So I can go back here to Excel and say 917 days and then put in the numbers for the 26, 15, 26.15, and then 30, 19.

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So I got an annualized return again. And again, the whole point of this is to turn everything into the same units of measure, annualized returns.

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So one thing, notice that if your holding period return is one year, your annualized is your annual.

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You remember, you see that? If it is a one year holding period, then your annual and your annualized will come out to be the same.

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However, if they are different, then you just use this little trick of Excel that I've given you right here.

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So just download this newest version of the sheet and you'll have this if I ask one on an exam.

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I'm not saying that I would, but on a midterm, this makes you look like a hero if you can quickly spit out the answer.

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If I give you a holding period of let's say you held it for 12 years and you started with this and you ended with that, what is the annualized rate of return?

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And you can just push it in here and out comes your answer. Now there are actually in your calculator, there's a way to do this.

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Do you see this calculator turns off to save battery? Why? Anyway, okay.

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You could use the formula, but there is actually a way in here to do it as well.

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As a matter of fact, let me show you something here. Apps, finance, there is actually a routine called DBD.

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There it is. Where you can actually put in two dates and get the number of days between them.

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But you don't need to worry about that. Like I said, I'm not going to do one where you have to actually calculate days.

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But it's there for you if you need it at some point for your own purposes.

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But that's for you to use as a way to just begin to see and make sure that you see the formula.

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Like for example, this formula here, I nothing took in the days one.

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I took the number of days, or rather, I took the ending value divided by the beginning value, D3 over D2.

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I raised that to 1 over, and then I took the days divided by the years to turn it into decimal of years.

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And then I did my minus 1. That's all I did to create this formula.

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And that's the kind of ability that I want you to finally, by the end of this course, begin to say,

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okay, I can do this kind of formula architecture and make my life a lot easier for problems that I encounter.

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In courses, in homework, and also if you run into this stuff in your personal or professional life.

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Now I'm going to take you on a bit of a journey here.

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It's partly story-based.

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And it's kind of a, you might even find it to be a little bit disturbing what I show you, what I teach you about.

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But taking this off the books, off the map here, take you on a bit of a story.

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Now in the world of finance, economics, and all of that, we always annualize.

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Well, if we possibly can. So that we're not, there's no haze, there's no question of what the holding period is.

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So if I were to talk about the yield on a bond, I would know that the answer, or if I saw a number for the yield,

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it would be an annualized amount of money.

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So, taking that as the starting point, reminding you, and again, I'm going to use these terms, rate, yield, return, kind of interdependently, interchangeably I should say.

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Now you remember that the formula for an interest rate is the risk-free rate plus the default premium plus the maturity premium plus the illiquidity premium.

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Another nice to have in your note card for the exam. Now you remember that the risk-free rate is the real rate plus the expected inflation premium.

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Now we work on the assumption that all rates are underlaying by that rate. It parks there as the base of all rates.

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I could even tell. Sir, do you have a skeleton?

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I hope so.

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Well, we'll say that you do because you're not...

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I haven't seen it yet.

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Well, I mean, I don't like those pictures. I saw a picture of my, this CT scan of me. God, actually I was better looking than I am with my skin on, but that's just me.

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You have a skeleton, and of course you do too. And we all have one. You don't have to see it.

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I mean, if you see it, you have a little accident and you see your skeleton sticking out.

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With me, I ate some ungodly hot sauce and my skull came out to get some air. But aside from that, we don't see it, but it's there.

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So the risk-free rate is going to sit there underneath all of us. And the risk-free rate sits there underneath all interest rates.

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It has to be the baseline of interest rates. If you had some investment, we promise you negative 18 percent.

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Well, how much would I get on a T-bill? 4 percent?

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Well, you would never do an investment that did not provide at least the risk-free rate.

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And then some based upon those risk-premia pieces.

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Okay, so that's sort of the baseline of it.

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Now, the next thing here is that another one that we would see the same number in any class of investments or securities.

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Would be the risk of the maturity premium, R sub M.

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If two bonds are both 10-year bonds, they should have the same maturity premium.

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If a one-year treasury bill and a one-year piece of commercial paper from a private corporation, they are both going to last a year.

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So they are both exposed to exactly the same risks of interest rate volatility over a year.

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Ah, I forgot to bring it. Okay, we'll just do it this way.

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So the maturity premium, if they're the same number of years, they should be the same.

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The only ones that would be different would be the default premiums and the illiquidity premiums.

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Now, if we're talking about high-quality investments, there should be virtually no illiquidity premium.

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That starts to show up when you have things that are very difficult to get rid of.

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A bank would have a hard time selling its car loans.

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A bank that made a loan on a promissory agreement, that would have a hard time selling those.

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A junk bond would actually, if an investor had a junk bond and wanted to dump it, sell it,

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he might have a while before anyone would pick that bond up in the secondary market.

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I actually had, well, I've got a better story, but I actually had a junk bond for a while,

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and I decided this isn't going anywhere, I'm going to lose my shirt on this thing,

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and I put in the order to sell it, that thing didn't transact for like three days.

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You know, usually when you put in a sell order, it's done with a normal stock or with a normal bond.

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But with junk bonds, that's not always the case.

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But anyway, now let me get back to something here.

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Suppose that we have a corporate AAA bond, something that's really high quality.

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I can get rid of that instantly, so there's no illiquidity premium.

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Now the R, its yield, is going to be the risk-free rate, which is the same for everything,

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plus it's going to have the corporate default on AAA,

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the default premium on AAA corporate bonds, which should not be much, but it's there.

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Plus the maturity, let me write it up here, a 10-year,

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plus the maturity premium on a AAA corporate bond that's 10 years in duration,

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plus the illiquidity premium on a AAA corporate bond.

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Bear with me, I'm getting there.

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Well, you know, that might be what?

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We see that the yield on that bond right now is 4.68%.

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Well, here we go.

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What if we look at a 10-year government treasury note?

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That thing that I've been showing you every day, one of those.

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Okay, well, R for that one would be the risk-free rate, plus the default premium on a government bond,

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plus the maturity premium on a government bond, plus the illiquidity premium on a government bond.

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You notice that those three pieces are going to be individualized.

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However, in this case, there's a couple of special things.

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First things first, the corporate and the government,

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a AAA corporate bond and the government bond will both have illiquidity premiums of zero.

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You can get rid of them right away. There's no cost to it other than maybe a transactions fee.

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Another one.

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These are both 10-year, so their maturity premiums should be identical.

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So I'm working my way down here.

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I'm going to subtract the top corporate from the bottom government.

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So the illiquidity premium, zero minus zero, is going to be a zero.

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The maturity premiums are going to be the same.

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So the corporate maturity premium and the government maturity premium are going to be the same.

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So when you subtract them, you get zero.

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Now, the default premium on the AAA, there is no default premium on the government bond.

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It won't default, not withstanding.

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No, well, now look, when the government owes money, one, it can print money, right, which we do all the time,

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or, of course, it could, if necessary, we could raise taxes on some poor sucker middle class people to pay it,

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or if that fails, we can just declare war on a country on false grounds and take over the country and liquidate everything in it,

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which we do. We're not going to default.

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And, you know, the next time we get close to it, we'll just maybe have a war and I'll recommend you for combat.

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So in other words, this one, R sub D of the AAA corporation bond,

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minus zero for the R sub D of the government bond, leaves us with the default premium.

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Risk-free rate minus risk-free rate is zero.

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So in other words, if I take a corporate AAA bond and subtract the yield on a corporate AAA bond

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minus the yield on the same maturity of a government bond,

254
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I should be able to get the default premium on corporate AAA bonds.

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That's how we tease them out.

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So if I suppose that I know that the T-bill of the corporate bond is right now at a yield of 6.8 percent

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and the government bond is at 4.35 percent,

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then I know that the default premium is 33 basis points.

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Why is this important?

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We watch this day to day, week to week.

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If that default premium starts getting bigger,

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we know that the markets are sensing trouble in corporate America with the economy.

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As it shrinks, we know that there is less possibility of default in corporate America in the high grades,

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and that will tell us the economy is doing well.

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It's one of our hidden ways that we can watch what the markets are assessing

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as the sentiment about defaults in the corporate world.

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We can do this with single A and double A as well.

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Just to see, keep an eye on, is the default premium expanding?

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Is it staying the same? Is it contracting?

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Is it getting bigger for the A's but not for the AAAs?

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Well, that would tell us that there's problems in the lower ranks of American corporations.

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It's one of our health checks, and it's a useful one too.

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Now, one brief caution. You can't really do this with grades below A,

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because you begin to get into problems with the illiquidity premium.

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It's not zero on the corporate bonds.

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It's a little harder, as I mentioned, to dump a junk bond than it is a high quality investment grade bond.

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But for the upper level bonds, the AAAs, AA's, single A's,

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it's a decent way to keep an eye on the pulse of various levels of corporate America

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and what the markets are assessing their default risks are.

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Right now, that default premium has been shrinking over the past six months.

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Well, the past three months, definitely.

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So we do know that from looking at that default premium on corporate bonds,

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which we get by just taking the average of the corporate bonds

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minus the average of that 10-year treasury bond,

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we get a measure and we see that, yeah, the markets are seeing less and less chance

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of default of the big dog corporations.

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This is never very big.

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If this thing gets up to more than like 80 basis points, that's scary.

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It's usually maybe 15 basis points or something like that.

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But I just did this one for emphasis.

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Now let me show you something.

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Let me get this stuff off the board.

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We have a graphic and the numbers behind it that we keep an eye on

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because it tells us something.

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It's one of the ways that we have historically been able to see the future through a dark crystal ball.

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It's called a yield curve.

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And as its name implies, you take time to maturity of different maturities of the same bond

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and you graph those against a vertical axis, which is the yield on those.

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In our case, what we've used traditionally are treasury debt securities.

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All the way from three months, plot the yield on a three-month, on a six-month, on a one-year,

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on a two-year, three-year, five-year, seven-year, and we get a graph of the yields.

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What they should look like.

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The yield should rise because of the maturity premium.

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The time to maturity gets longer, the maturity premium.

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Everything else about it being the same, R sub D, R sub F, R sub IL,

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but the maturity premium should give us a nice upward rising yield curve.

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That's healthy.

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Now if it rises too fast, that can be a little bit worrisome

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because that tells us that the markets are expecting future inflation to accelerate.

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So you don't want to go way too fast.

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But a nice, smooth, rising yield curve should be a glorious thing.

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It's a normal economy.

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Unfortunately, for about a year, more than a year now, we have had,

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the technical name for it is a weird-ass economy.

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It is strange. It's not behaving.

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And the yield curve is really misbehaving.

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Now let me show you something.

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A couple of yield curves that you don't like.

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A yield curve that would be downward sloping, that's virtually an apocalypse.

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We don't ever want to see one like that.

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That would be a marker of a really great depression or a deflation.

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Something that we really, we hate inflation.

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We really don't ever want to see a deflation.

324
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Well what's wrong with that? Price is going down.

325
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Yeah, it's because the economy is closing its shop forever.

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We don't want to see that one ever.

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There's one that we do see from time to time.

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And this is one that we can use for forecasting.

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Because if one of these happens, you're looking one day and suddenly it looks,

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the yield curve looks like what I'm about to show you,

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we know that there is probably going to be a recession within six to nine months.

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That's how serious it is.

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The one I'm going to show you, every recession has been preceded by the one I'm going to show you.

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Every recession.

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Now, not always does this one, if you see it, will there be a recession.

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Sometimes it just barely skids by a recession, but we definitely have a downturn.

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The one I'm about to show you here is called an inverted yield curve.

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An inverted yield curve starts out nice, and then it has a place in it

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where a longer term yield is below the yield before it.

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That would be an inverted yield curve.

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Like the seven year yield might be 6.5% and the ten year yield would be 6.3%.

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You see it not going in the right direction.

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Now the first thing I'm going to do, I'm going to find you a normal yield curve.

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A normal yield curve.

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Let's try 2016. That should be a normal yield curve, I hope.

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Yeah, see it? January 1 of 2016.

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Some of those, they didn't have those treasuries.

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These are all treasury yields.

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Do you see how it just climbs very pretty?

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Do you see that? Nice.

351
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That's a classic healthy yield curve at the end of 2016.

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Now let's take us to the end of, let's get here to the end of 2020.

353
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Take us clear down to the bottom.

354
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And we still had a normal yield curve.

355
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Now let's take us to the end of 2021.

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And see what happens.

357
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Still normal.

358
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Now let's take us to the end of 2022.

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Come on.

360
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2022.

361
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And something begins to happen.

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Look.

363
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Do you see it?

364
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The yield curve, oops, actually.

365
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Do you see there? The yields should be going up, but they're going down.

366
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Inverted. And that was a heavy inversion.

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We expect an inversion to be maybe two or three of these numbers are lower than the one before.

368
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One or two or three.

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But there by the end of 2022 we had an inverted yield curve.

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And it was a scary inversion.

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Of course, economic forecasters are saying, well that means that we're probably going to have a recession within six to nine months.

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Well, we had an economic pause. You wouldn't call it necessarily a recession.

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See, a recession is two consecutive quarters of negative growth of GDP.

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So if you have one quarter of negative growth, that's not a recession.

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But it's still an economic downturn.

376
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If you had two quarters of zero economic growth, that's technically not a recession, but it still means that the economy slowed down.

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And that's what happened.

378
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But now let's take us to right now.

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We are in an economic recovery.

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Some would argue we've actually entered an expansion now.

381
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Look at this.

382
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Clear back to here.

383
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Clear back to one of the shortest T-bills on forward.

384
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Clear out to the 20-year.

385
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It's inverted.

386
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Today.

387
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Now.

388
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It never corrected itself.

389
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If I am not mistaken, that's the first time we've ever seen this happen.

390
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We are in a recovery, an expansion.

391
00:53:32,000 --> 00:53:39,000
The yield curve inverted months and months ago, and it never got right.

392
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You're seeing something that I've never shown before in a class.

393
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Well, except for the last semester, couple of semesters.

394
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An inverted yield curve with no evidence of a recession coming.

395
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At all.

396
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We've recovered.

397
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Now, once an economy begins to recover, the yield curve should correct itself.

398
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It should come back to behaving like a normal, looking like that.

399
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Maybe it will be unstable for a while, dip and then come back up, but it should eventually get itself right.

400
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And this yield curve isn't doing it.

401
00:54:17,000 --> 00:54:20,000
That is very unusual.

402
00:54:20,000 --> 00:54:29,000
If I'm not mistaken, that's unique in the economic history for which we have the data to be able to do yield curves,

403
00:54:29,000 --> 00:54:32,000
which is nearly a century of data, for heaven's sakes.

404
00:54:32,000 --> 00:54:34,000
We've never seen this before.

405
00:54:34,000 --> 00:54:37,000
So that's what's weird about this.

406
00:54:37,000 --> 00:54:42,000
Does that mean that we're going to get another recession, what we call a double-dip recession?

407
00:54:42,000 --> 00:54:45,000
It doesn't seem to be saying that at all.

408
00:54:45,000 --> 00:54:50,000
We don't see any signs of a turn down, of a downturn.

409
00:54:50,000 --> 00:55:00,000
But there it is, right in front of us, looking at us stupid, like somehow this is supposed to be a normal thing.

410
00:55:00,000 --> 00:55:08,000
I can't tell you where it is from here, but this gives you a visual idea of a yield curve.

411
00:55:08,000 --> 00:55:16,000
Now, from the data, they won't let me keep my own bookmarks up here.

412
00:55:16,000 --> 00:55:17,000
It just keeps wiping them out.

413
00:55:17,000 --> 00:55:25,000
So I'm going to have to dig in here really quick and see if I can find it.

414
00:55:25,000 --> 00:55:28,000
Yield curve.

415
00:55:28,000 --> 00:55:35,000
I'm looking for one that's called visualization.

416
00:55:35,000 --> 00:55:41,000
There's a site that does a really nice one, but I don't know if they have it.

417
00:55:41,000 --> 00:55:46,000
Stock charts used to have a really nice one, a dynamic yield curve.

418
00:55:46,000 --> 00:55:52,000
Here it is.

419
00:55:52,000 --> 00:55:54,000
Oh, hell.

420
00:55:54,000 --> 00:55:58,000
No, I don't want to see that.

421
00:55:58,000 --> 00:56:01,000
I don't think that's what I want to show you.

422
00:56:01,000 --> 00:56:04,000
Oh, come on.

423
00:56:04,000 --> 00:56:07,000
Oh, never mind that.

424
00:56:07,000 --> 00:56:10,000
There's what I want to see.

425
00:56:10,000 --> 00:56:11,000
Okay.

426
00:56:11,000 --> 00:56:14,000
Well, that one's old history.

427
00:56:14,000 --> 00:56:16,000
That one's old.

428
00:56:16,000 --> 00:56:18,000
Find something else.

429
00:56:18,000 --> 00:56:21,000
I don't know where I would...

430
00:56:21,000 --> 00:56:24,000
I'm not going to try to find it on here.

431
00:56:24,000 --> 00:56:28,000
There's one that I always used to show, and it's not here right now.

432
00:56:28,000 --> 00:56:30,000
I can't see it.

433
00:56:30,000 --> 00:56:33,000
But what I will do is put up a link to this.

434
00:56:33,000 --> 00:56:36,000
And it's a good piece to look at.

435
00:56:36,000 --> 00:56:39,000
So what's going on?

436
00:56:39,000 --> 00:56:46,000
The only thing that could possibly be driving that yield curve, the way it's behaving,

437
00:56:46,000 --> 00:56:50,000
well, there's actually one factor that might.

438
00:56:50,000 --> 00:56:54,000
But this is a treasury.

439
00:56:54,000 --> 00:56:57,000
There's no default premium, no illiquidity premium.

440
00:56:57,000 --> 00:57:02,000
The only thing that could be driving it is the maturity premium,

441
00:57:02,000 --> 00:57:08,000
which that yield curve is saying is actually getting smaller the longer you go.

442
00:57:08,000 --> 00:57:11,000
That would be like firing water out of a hose

443
00:57:11,000 --> 00:57:16,000
and having it on its own get smaller as it went forward in time.

444
00:57:16,000 --> 00:57:20,000
There's only one other explanation.

445
00:57:20,000 --> 00:57:23,000
Expected inflation premium.

446
00:57:23,000 --> 00:57:30,000
It might be that those longer rates are using a lower and lower expected inflation premium

447
00:57:30,000 --> 00:57:33,000
than the shorter rates are.

448
00:57:33,000 --> 00:57:37,000
That would actually be a really great thing if that's what's going on.

449
00:57:37,000 --> 00:57:40,000
I don't think we've ever seen it before.

450
00:57:40,000 --> 00:57:47,000
But that would be the only other explanation that could drive this.

451
00:57:47,000 --> 00:57:56,000
Is that these rates out here at the 2, 3, 5, 7, 10 year mark,

452
00:57:56,000 --> 00:58:05,000
they are saying that the expected inflation premium out there is going to be lower than it is back here.

453
00:58:05,000 --> 00:58:11,000
The main reason I'm doing this is just to get you used to using the thinking of how interest rates work.

454
00:58:11,000 --> 00:58:17,000
But the background is to be able to think ahead of the box,

455
00:58:17,000 --> 00:58:22,000
knowing what's in the box, but to say, is there something else that could be going on here?

456
00:58:22,000 --> 00:58:26,000
And the answer is maybe the expected inflation premium.

457
00:58:26,000 --> 00:58:31,000
That's the only thing that could be doing this other than the maturity premium.

458
00:58:31,000 --> 00:58:38,000
And if that is what's happening, we're seeing the first inverted yield curve that is not a warning sign.

459
00:58:38,000 --> 00:58:45,000
It's actually a good sign that something, but who knows?

460
00:58:45,000 --> 00:58:48,000
That's out of my pay grade for right now.

461
00:58:48,000 --> 00:58:54,000
Now the next thing I want to show you, I'm going to reach out here.

462
00:58:54,000 --> 00:58:57,000
Let me take this rate right here.

463
00:58:57,000 --> 00:59:04,000
No, I can't, because these stupid rates are stupid.

464
00:59:04,000 --> 00:59:08,000
You can't do this with an inverted yield curve.

465
00:59:08,000 --> 00:59:17,000
Well, you can, but it's not particularly good.

466
00:59:17,000 --> 00:59:25,000
I'm going to just take a one-year, a two-year, and a three-year.

467
00:59:25,000 --> 00:59:36,000
Now let's say that the one-year yield, these are all annualized, the one-year yield is let's say 4.20%.

468
00:59:36,000 --> 00:59:48,000
The two-year is 4.35%.

469
00:59:48,000 --> 00:59:52,000
Got a rising yield curve, normal stuff.

470
00:59:52,000 --> 00:59:58,000
Okay, that is an annualized yield on a two-year.

471
00:59:58,000 --> 01:00:09,000
So we've got the rate on a one-year is 4.20%.

472
01:00:09,000 --> 01:00:19,000
The rate on a two-year is 4.35%.

473
01:00:19,000 --> 01:00:29,000
The problem with that is that that is an annualized yield that was actually the composite of two.

474
01:00:29,000 --> 01:00:51,000
This is 4.35% annualized over two years.

475
01:00:51,000 --> 01:00:54,000
Over two years.

476
01:00:54,000 --> 01:00:59,000
So in other words, that's actually two interest rates.

477
01:00:59,000 --> 01:01:15,000
It's one plus the one-year, 0.0420, times another one-year rate that we don't know.

478
01:01:15,000 --> 01:01:26,000
And together, those two make one plus 0.0435 to the second power.

479
01:01:26,000 --> 01:01:29,000
This is a pain in the ass.

480
01:01:29,000 --> 01:01:33,000
It's one of the more complicated concepts in the class.

481
01:01:33,000 --> 01:01:44,000
Is that this X is what we call the forward rate for two years on year two.

482
01:01:44,000 --> 01:01:56,000
Because what we're seeing with our eyes is a composite that we just say is some rate to the second power.

483
01:01:56,000 --> 01:02:03,000
Working this out, and I would never do this on a test because I don't want to get my tires slashed,

484
01:02:03,000 --> 01:02:06,000
but I think they have a problem in the homework.

485
01:02:06,000 --> 01:02:09,000
So the way you would do this.

486
01:02:09,000 --> 01:02:11,000
Whoops, let me do this.

487
01:02:11,000 --> 01:02:27,000
One plus X is going to be 1.0435 to the second power over 1.042.

488
01:02:27,000 --> 01:02:38,000
And then so X is going to be 1.0435 squared over 1.042 minus one.

489
01:02:38,000 --> 01:02:44,000
I'm going to do this and then just give you what it kind of means.

490
01:02:44,000 --> 01:02:55,000
So if I were to take that, and of course I deleted my calculator, I closed the calculator, so I'll try it again.

491
01:02:55,000 --> 01:03:20,000
I'm going to take 1.0435 squared divided by 1.042 minus one.

492
01:03:20,000 --> 01:03:45,000
That's saying that X is going to be our forward rate, the second year forward rate is going to be 4.5%.

493
01:03:45,000 --> 01:03:47,000
4.50%.

494
01:03:47,000 --> 01:03:58,000
So in other words, for one year we'll have 4.20%, the next year we'll have 4.5%,

495
01:03:58,000 --> 01:04:11,000
but that means that overall we will have for the two years 4.35%.

496
01:04:11,000 --> 01:04:17,000
Now take it as far as you want, I won't ask for a forward rate on a quiz or an exam,

497
01:04:17,000 --> 01:04:21,000
but they do cover it in the book and it is kind of noteworthy.

498
01:04:21,000 --> 01:04:31,000
If this were what the economy was doing, you would see that the forward rate is for the second year is higher than this rate,

499
01:04:31,000 --> 01:04:34,000
than the rate we'll have for the coming year.

500
01:04:34,000 --> 01:04:39,000
What that means with that inverted yield curve, if you think about it,

501
01:04:39,000 --> 01:04:45,000
that would mean that the forward rates, in order for the whole yield curve to decline,

502
01:04:45,000 --> 01:04:50,000
each forward rate would have to be less than the year before it.

503
01:04:50,000 --> 01:05:01,000
So what this is saying is that the markets think that interest rates are going to be falling for the next 20 years,

504
01:05:01,000 --> 01:05:07,000
if the curve is inverting that long, and again the only way that could probably happen is

505
01:05:07,000 --> 01:05:14,000
if the Fed is easing monetary policy, or the real rates falling,

506
01:05:14,000 --> 01:05:20,000
or expected inflation is supposed to just vanish.

507
01:05:20,000 --> 01:05:38,000
You guys better get down to getting your test ready now.