Introduction to the yield curve | Stocks and bonds | Finance & Capital Markets | Khan Academy

Welcome back. Before we proceed further and
get a little bit better understanding of why maybe some
of these investors were so keen on investing in mortgage
backed securities, essentially loaning this money
to all these people who are buying these ever appreciating
houses, I think we need to a few more tools in
our tool belt. So I'm going to introduce
you to the concept of the yield curve. You might have heard
this before. You might have heard people
on CNBC talk about it. And hopefully, after about the
next five or ten minutes, you will know a lot about
the yield curve. So when most people talk about
the yield curve, they're talking about the treasury
yield curve. And what does that mean? What is even a treasury? So these treasury securities,
whether they're T-Bills, treasury bills, treasury notes,
or treasury bonds. These are loans to the
federal government. And these are considered
risk-free. Because if you lend to the
federal government and they're running short of cash, all they
have to do is increase taxes on us the people and they
can pay back your debt. So in dollar denominated terms,
the treasury bills, notes, and bonds are about as
safe as you can get in terms of lending your money
to anyone.

So when most people talk about
the yield curve, they're talking about the risk-free
yield curve. And they're talking about the
curve for treasuries. So first, a little bit
of definitions. What is the difference between
treasury bills, treasury notes, and treasury bonds? They're pretty much all loans
to the government. But they're loans for different
amounts of time. So if I give a loan to the
government for $1,000 for six months, that will be
a treasury bill. So I will give the government
$1,000, the government would give me a treasury bill. And that treasury bill from the
government is essentially just an IOU saying that I'm
going to give you your money back in six months with
interest.

Similarly, if it's three months, it's a three
month treasury bill. Treasury notes are loans that
are from one year to 10 years. So on this graph that we're
going to make using the actual yield curve rates, from zero
to one year– and actually there's no zero year
treasury bill. Actually, the shortest
one is one month. This would be something like
here on our graph. So from one month to one year,
these are T-bills. And this is just definitional. Then from one year to 10
year, these are notes. Actually, I believe the one
year itself is a note. Up to one year is a bill. Although, I might be
wrong with that. Correct me if I'm wrong. That's just a definitional
thing. From one to 10 year, these
are called notes. And then when you go beyond
10 years, these are called treasury bonds. These are just definitional
things to worry about. So with that out of the way,
let's talk about what the yield curve is.

I'll just give you a simple
thought experiment. If I'm lending money to someone
for a month versus lending money to that person for
a year, in which situation am I probably taking
on more risk? Well, sure, if I'm lending
someone for a month, I know only so much can happen
in that month. So I would expect to be paid
less interest. Not just obviously in dollar terms, but
even adjusted for time, I would expect less interest
for that month. And this is actually an
important point to make. When I say that I'm charging
6% interest for that month, that doesn't mean that after a
month the person is going to pay me 6% on my money. It means that if I were to give
that money to somebody for a month, and they
were to pay it back. And then I were to give that
money to, say, that same person, or another person, for
a month, and I were to keep doing that for a year, then in
aggregate I would get 6%.

So that 6%, no matter what
duration we talk about, whether one month, one year,
five years, 15 years, when we talk about the interest rate,
that's the rate that on average we would
get for a year. It's the annualized
interest rate. So going back to my question. If lend someone money, even the
government, for a month, there's usually less
risk in that. Because only so much
could happen in a month versus in a year. In a year there might be more
inflation, the dollar might collapse, I might be passing on
better investments, I might need the cash in a year's time,
while I have a lot of confidence that I don't need
the cash in a month's time. So in general, you expect less
interest when you loan money for a shorter period time than
a longer period of time. And so let's draw the
yield curve and see if this holds true. So I actually went
to the treasury website, so that's treas.gov.

And this is the yield curve. So they say on March
14, so this is the most recent number. And I'm going to plot this. They say, if you lend money to
the government for one month, you'll get 1.2% on that money. And remember, if it's $1,000
it's not like I'm going to get 1.2% on that $1,000 just
after a month. If I kept doing it for a year,
this is an annualized number, I'll get 1.2%. And so for three months, I
get a little bit less. And then for six months
I get more. And then it does seem that the
overall trend is that I expect more and more money as I lend
money to the government for larger and larger
periods of time. And this is a little interesting
anomaly that you get a little bit more
interest for one month than three months.

And we'll do a more advanced
presentation later as to why you might get lower yields for
longer duration investments. That's called an inverted
yield curve. So let's just plot this and
see what it looks like. So you saw where
I got my data. So they say for one month
I'd get 1.2%. So this is one month. It'd be right about here. Three months I get about
the same thing. For six months I get 1.32%. Maybe that's like here. One year, I get one 1.37%. Maybe it's here. Five years, I get 2.37%. So that's maybe like here. And these aren't all
of the durations. I'm just for simplicity not
going to do all of them. For 10 years, 3.44%. So maybe that's here.

For 20 years, I get 4.3%. Like that. And then for 30 years,
I get 4.35%. So the current yield curve looks
something like this. And so you now hopefully at
least understand what the yield curve is. All it is, is using
a simple graph. Someone can look at that graph
and say, well, in general what type of rates am I getting for
lending to the government? On a risk-free free basis, or
as risk-free as anything we can expect, what type of rates
am I getting when I lend to the government for different
periods of time? And that's what the yield
curve tells us.

And in general, it's
upwardly sloping. Because, as I said, when you
lend money for a longer period of time, you're kind of
taking on more risk. There's a lot more that you
feel that could happen. You might need that cash. There might be inflation. The dollar might devalue. There's a lot of things
that could happen. So the next question
is, well, what determines this yield curve? Well, when the treasury, the
government, needs to borrow money, what it does is say, hey
everyone we need to borrow a billion dollars from
you, because we can't control are spending. And they say we're going to
borrow a billion dollars in one month notes. So this is one month notes. They're going to borrow
a billion dollars. And they have an auction. And the world, investors from
everywhere, they go in, they say, well, this is a
safe place to put my cash for a month. And depending on the demand,
that determines the rate.

So if there are a lot of people
who want to buy those one month treasuries, the rate
might be a little bit lower. Does that make sense to you? Think about it. If a lot of people want to buy
it, there's a lot of demand relative to the supply. So the government has to pay a
lower interest rate on it. Similarly, if for whatever
reason people don't want to keep their money in the dollar,
they think the U.S. might default on their debt
one day, and not that many people want to invest in the
treasury, then that auction, the government is going to have
to pay a higher interest rate to people for them
to loan money to it. So maybe then the auction
ends up up here. And similarly, the government
does auctions for all of the different durations.

And duration, I just mean
the time period you're getting the loan for. So they do it for one month,
three months, six months, one year, two year, three
year, et cetera. Once the government has done
that auction– You give the money to the government,
they give you an IOU called a T-bill. Then you could trade it
with other people. And that's going to determine
the rate in the short term. So the government does
the auction. But then after the auction,
and a lot of people had demand, but then a lot of
people get freaked out. And the public markets, when you
try to sell that treasury, will then expect.

A higher yield. I know that might be a little
complicated now. And I always start to jumble
things when I run out of time. But hopefully at this point you
have a sense of what the yield curve is. You have a sense of what
treasury bills, treasury notes, and treasury bonds are. And you have some intuition
on why the yield curve has this shape.

See you in the next video..

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