ProfessorJohnGeanakoplos:
Okay,soIthinkIshouldstart.Hello.Allright,solasttimewebegan,ormaybetwotimesago,webeganadiscussionofvariousvocabularyandfactsyouhavetoknowaboutthemarketsifyouwanttothinkaboutfinance.Todaywe'regoingtodealmostlywiththemostimportantone,themostbasicone,theyieldcurve.Andlasttime,weintroducedthisword,"yield."
Now,yieldisanextremelycommonexpressioninfinance,anditturnsoutnottobethatwelldefined,often,orthatuseful.Butthewordissoimportantandhasbeenusedsooftenthatitstillhangsaround,evenwhenprobablyweshouldusedifferentconcepts.
Soremembertheyieldwasanattempttolookataninvestment,andwithoutpayinganyattentiontothemarketoranythingoutsidetheinvestment,justlookingattheinvestmentitself,trytoassess,giveanumber,quantifyinghowattractivetheinvestmentwas.Sowesaidyoucouldapplythattoabond--ithascashflows.Youcouldapplyittoahedgefundthat'stakinginmoneyandpayingoutmoney,andtheformulawecameupwithsaidthatifthecashflowsaregivenbyC
（1）,C
（2）,thenetcashflows,C（T）overthecourseoftheperiod,anditspriceissomeP（0）,maybeit'sanegativecashflow,soC（0）.Sosomeofthesecashflowsmightbenegativeandsomeofthemmightbepositive,thenweshouldjustlookatthenumberY,suchthatdiscountingallthesethingsatrateYgivesyou0.TheYthatdidthatwaswhatwedefinedastheyieldoftheinvestment.
Sowesawthatthathadsomeadvantages.Forexample,inahedgefund,ifyoujustlookattherateofreturnitmakesonitsmoneyeveryyear,thatdoesn'ttakeintoaccountthatinsomeyears,it'sgotalotmoremoney.Soifthoseweretheyearsthatlostmoney,andtheyearswhenithardlyhadanymoneyweretheyearsitmademoney,justtakingtheaverage,themultiplicativeaverage,thegeometricaverageofallthoseyearlyratesofreturns,wouldgiveamisleadingfigure.
Well,theyieldalsogivesasomewhatmisleadingfigure,andIdon'twanttospendtoomuchtimeonwhyitmightbemisleading,butI'llgiveyoujustanexample.Supposethatthecashflowshappentobe1,-4,and3.Nowwhat'stheyieldtomaturity?
Well,therearetwoofthem.YoucouldhaveY=0,because1over（1+0）,+-4over（1+0）,+3over（1+0）,isjust1-4+3.Thatequals0,sotheyieldtomaturityof0percent,theyieldof0percent,makesthishavepresentvalue0.ButalsoIcouldtryY=200percent,andthenI'dhaveY--I'dputa+2anda+2squaredhere,andI'dhave+1-4thirds+1over3squaredis3over9,soit's+1third.Soitwouldbe1minus4thirds,plus1third,whichalsoequals0.Soistheyieldtomaturity,theinternalrateofreturn0percentor200percent?
It'sambiguous.Soyieldtomaturitycan'tbetherightwayofdoingthings.
Togobacktothehedgefundexample,youknow,thehedgefundwastakinginmoney,payingoutmoney,takinginmoremoney,payingoutmoney,andwecalculatedtheyieldtomaturity.Wellsupposethattherewassomeperiod,youknow,here,atwhichpointeveryonehadtakenalltheirmoneyout,sothehedgefundwasn'tactuallydoinganythingforabunchofyears,maybeforalongtime,andthenitstartedupandtookmoneyinandpaidmoneyoutandstuff.
Well,becausethegapintimewasverylongwithnothinghappening,ifyoutakeapositiveY,thestuffthathappensinthesecondincarnationofthefundishardlygoingtobemakinganydifference,becausebythattime,itwillallbediscountedalot.Sotheyieldwilldependtoosensitivelyonstuffearlyratherthanstufflate.Andsoagain,yougetintotroublesyieldingjustyieldtomaturity,sothatcan'tbetherightthingtodo,eventhoughpeoplehavedoneitforyears.Sotheword,however,liveson,andthere'snogettingridofthewordbecauseit'susedincommonvocabulary.
NowwhatwouldIrvingFishersayyoushoulddo,ifyouhadtosummarizehowgoodaninvestmentwas?
What'shislesson?
Whatdoyoudo?
Aninvestmentwherethere'snodoubtaboutwhatthecashflowsaregoingtobe,whatwouldhesayyoushoulddo,toevaluatetheattractivenessofit?
What'sourlesson,ourmainlessonfromIrvingFisher?
Whatwouldhesay?
Yes.
Student:
[inaudible]liketocheck?
ProfessorJohnGeanakoplos:
Well,let'ssaythey'recashflows,soit'smoney,moneythatyou'regoingtogetcominginandout,yeah,he'dsay,deflatebyinflationandturnthemintorealflowsandthendowhat?
Sojustcontinueyouranswer.Soturnthemintoactualpotatoeseverytime,appleseachtime.Deflatebyinflationandthendowhatwiththenumbers?
Thisisasimplequestion.You'rethinkingtoohard.Yes?
Student:
Comparethepresentvalue.
ProfessorJohnGeanakoplos:
Okay,he'dsay,"Justlookatthepresentvalueofallthesethings."Soofcourse,todothat,you'dhavetoknow,whatisthemarketrateofinterestwithwhichtocomputethepresentvalue?
SoFisherwouldsay,"It'sridiculoustoevaluatehowgoodaninvestmentopportunityisjustbylookingatthecashflows.You'rethrowingawaytoomuchinformation."
Youknowwhatthemarketisdoing,youknowwhattheinterestratesare.Usethemarketinterestratesandfigureoutwhatthepresentvalueofallthecashflowsis.Sowe'regoingtonowdothatabunchoftimes,okay,fortherestoftheclass,andseewhatthatmeans.Sowehavetobegin,thetwothirdsoftheclassisgoingtobespentonthequestion,howdoyouknowwhatthemarketratesofinterestare?
Sohowdoyouknowwhatthemarketratesofinterestare?
Howcouldyoufindoutwhatthemarketrateofinterestis?
Whatwouldyoudotofinditout?
Yeah.
Student:
Youcouldgotoabankandseewhattheywereestimatingittobe.
ProfessorJohnGeanakoplos:
Andifyoulookedinthenewspaper,say,couldyoufinditinthenewspapers?
Whatwouldyoufindinthenewspapers?
Yes?
Student:
You'dwanttofindarisklessinvestment,saylikeaT-bill.
ProfessorJohnGeanakoplos:
Okay,andsoyes,youtryandlookatrisklessinvestmentslikegovernmentbonds,wheretherecan'tbeanydefault--atleast,that'swhattheyalwaysusedtosay--can'tbeanydefaultonanAmericanpromise.America'sgovernmentneverbrokeapromiseandtheycanalwaysprintthemoney,sopresumablytheydon'thavetobreakapromise--sothey'rejustpromisingmoneywhichtheycanprint,sowhyshouldtheyeverbreaktheirpromise--sowhatwouldyoufindifyouopenedanewspaper?
Youwouldfind,fordifferentmaturities--itusedtobeupto30years--fordifferentmaturities,youwouldfindtheyieldonthevariousbonds,okay?
Sowhywouldyoufindtheyield?
Well,theyieldofvariousgovernmentbonds,ofgov.bonds.Whydotheyquotetheyield?
Well,that'sjustbecause,youknow,ahundredyearsago,peoplestartedusingtheideaofyieldandsothevocabularyhasbeenkept,eventhoughit'snotthebestwayofdescribingwhat'sgoingon.Soforinstance,let'sjustlookatsomeoftheyieldcurvesyoumighthaveseenoverthelast9years,almost10years,sinceDecember2000.YouwouldseethatinDecember2000,theyieldonthe1-yearbonds,youknow,theshortyields--thisisn'talogscale,sothisis3,6,12,okay.Sotheshortestbondsusuallyhaveloweryieldsthanthehighestbonds,butsometimes,likeinDecember2000,theyieldsarealmostallthesame.It'scalledtheflatyieldcurve.
Othertimes,likenow,we'reinthislightblueonehere,rightnowtheshortbondshaveverysmallyieldsandthelongbondshavemuchhigheryields,sothelastoneisthe30-yearbond.Soyougettheyieldoneverysinglebond.
Nowwhatdoyounoticeaboutthispicture,bytheway?
Theycanbeverydifferentatdifferenttimeperiods,soinDecember2000,theinterestrateswerereallyhigh.Theyieldswere6percent.I'mtalkingyieldssofar.Wehaven'ttalkedaboutinterestrates.
Wehavetofigureoutwhattheinterestratesare,butanyway,they'reobviouslygoingtobeconnected.SotheyieldswereveryhighinDecember2000,andtheygotmuchlowerinDecember2008,andthey'vestayedverylow.Sowhyaretheysolownow?
Whatgotthemtobesolownow?
Yeah?
Student:
TheFedfloodedtheeconomywithmoney.
ProfessorJohnGeanakoplos:
TheFedfloodedtheeconomywithmoney.Itwantedtodrivetheinterestratesdownto0.Sowe'regoingtoseeverysoonwhytheFedmighthavewantedtodothat,butthesemoneyratesdon'tmovetotallyontheirown.Theyhavetodo,andwesaidthatIrvingFisher--wehaven'tdescribedIrvingFisher'stheoryofmoneyandnominalinterestrates--butsomehow,theFediscontrollingthenominalinterestratesandit'schangedtheyieldcurve.
Soyounoticethattheyieldcurvenow,December2008,wasthisblueone.SotheFed,inthecrisisof2008,youknow,wasterrified,anditdroppedtheinterestratealmostto0,virtually0,andit'skeptitthere,becausefromDecember2008tillnow,we'reatOctober2009,September30th,2009,alongtimehaspassedfromthisdarkbluetothelightblueline,andtheratehasbeenkeptfixedthere.Butintheinterveningtime,thelongrateshavestartedtogowayup.Nowwhymightthatbethecase?
Whatdoesthatsuggesttoanybody?
Doesanybodyknow?
Yeah?
Student:
[inaudible]
ProfessorJohnGeanakoplos:
Thatcouldbeonereason,andcouldtherebeanotherreason?
Yeah?
Student:
Futureexpectedinflation.
ProfessorJohnGeanakoplos:
Okay,sothosearethetworeasons.Sotheysomehowknowthat,andsomeofyouhavenoideahowtheycouldpossiblybethinkingthat.AndsoI'mgoingtoexplain,whatinformationisthereinthedifferentyieldcurves.Okay,sothepointisthateverymorning,
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