Financial Theory Lecture 9 Transcript 2.docx
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Financial Theory Lecture 9 Transcript 2.docx
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FinancialTheoryLecture9Transcript2
FinancialTheory:
Lecture9Transcript
October1,2009
< 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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