Constant Yield Method

Finance, a la Shmoop. [title page]

What's the difference between normal, inverted, and flat yield curves, and what to they tell

us?

All right, well let's start with the basics.

Yield curve... ooh, sexy term. [guy talks about yield curves]

Say it a lot and people will think you know a lot about finance.... or that you're really [people are pretty impressed]

into slowing down while making gradual left turns. [pig thanks slow driver]

But in finance, a yield curve is just a graphic representation of bond yields, from "maturing [yield curves defined]

soon" to "not maturing for a really long time."

So here's a yield curve. [yield curve illustrated]

Note that the ticks on the bottom are time and, on the left--the vertical y-axis there--it's

percentage, or yield.

Well, this particular curve slopes oh-so-gently upward. [upward slope demonstrated]

You can see that bonds maturing in three months yield 2% and bonds maturing in 30 years yield

4.5%.

What does this say?

Well, it says that the debt markets believe that interest rates will be meaningfully higher [diagram explained]

in the future--like, more than double--and that, to some extent, there's risk in getting

those bonds paid off.

That is, money tangibly ready to be paid off in the next two months carries a lot less

investment risk than bonds three decades away. [roaches discuss bills]

Yeah, you never know, we could have this... [roaches watch nuclear destruction of world]

So this is a normal curve: Money near term yields less than money due far away.

Well, most of the time, this is how yield curves look.

But think about an era where the government is desperately fighting inflation and it raises [government fights inflation]

short-term borrowing rates massively. [rates increase]

Well this, in fact, happened in the 1970s when Vietnam's war economy, coupled with a [Vietnam War footage]

bunch of other elements, produced roaring inflation in the U.S.

So the Fed then raised short-term rates into the double digit zone, but most investors [rates increase]

believed that these very expensive short-term interest rates would stop people from borrowing

and buying stuff.

Think about your credit card charging you 25% a year in interest. [big credit card bill]

Ugh, that's a lot.

It'll make you think twice about putting that belly button ring set you saw at the mall

on your AmEx. [person doesn't buy belly button ring]

So when people stopped buying things on credit, well, they bought a lot less and the economy [tumbleweed in mall]

cooled, and then the Fed went ahead and lowered rates and the yield curve went back to normal. [rates decrease]

But for a while, the curve was inverted. [inverted curve demonstrated]

That is, is started with short-term rates very high, and then long-term rates were cheaper.

And as you might be able to guess, somewhere in the middle there, as the curves crossed

over, there was a short period where the yield curve was pretty flat. [flat yield curve demonstrated]

That is, the price of renting money is the same whether you're borrowing it for three

months or 30 years.

You know, that same 3.5% kind of rent.

Got it?

So now you've got curves, and you know how to use 'em. [pig admires curves]