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Current time:0:00Total duration:3:10

Annual interest varying with debt maturity

Video transcript

Let's think about 2 different scenarios where I might borrow money from you, So this is me over here, and this is you in the first scenario, I borrow money from you for a relatively short amount of time, so I'm gonna borrow $100 from you and then in 1 week I will pay that $100 back to you I will pay back the $100, and then I will pay some interest. And we'll calculate the interest on an annual basis, but obviously it will be less than a year's interest because I'm only paying for a week but we can annualize it, it would give us some annual interest. The other scenarios is I borrow for a longer period of time So I'll do the other scenario in pink right over here So let's say I borrow $100. Instead of paying you back in a week, we agree that I can pay you back in 2 years. I'm going to pay you back $100 plus some interest. And what I want to think about here is there any reason why on an annual basis, I should have a different interest rate for the short-term borrowing than the long-term borrowing You might say, "Look, it's the same guy that's borrowing, "...has the same credit rating, has the same kind of legitimacy" and all of that, but you would say, "Well look, "...over here in 1 week, there's less of a chance of something catastrophic happening" There's more predictability here, you have a better sense of what the world 1 week from now is going to look like, than you do 2 years maybe 2 years from now we enter into a hyper-inflationary environment maybe I get hit by a truck, maybe I lose a job there's a lot more that can happen in 2 years than can happen in 1 week. And so you say, "Look, I think that this loan right here is riskier" and it's not always the case that this would happen but many times you'd say look, if lending it for longer it's riskier there's more uncertainty, so on an annual basis I would charge higher interest, on an annual basis. Maybe in this scenario up here, you say "Look, I'll charge you 5% per year interest" So obviously the interest I would pay after a week would be some fraction of this, some small fraction of $5 or 5% and over here, since there's more risk, more uncertainty over 2 years I will charge you, or you will charge me I should say, 10% per year. And it's not always the case, that the longer maturity debt is going to have a higher interest, although it tends to be the case. If it goes lower we'll talk about it in a future video, it actually shows that something bad might be happening in the economy or we might somehow be entering into a deflationary period But the whole point of this video is to show you that depending upon how long someone borrows money from someone else, they might want to charge a different amount of interest per year depending on perceived risk, the same thing is true when people lend to corporations or to the Federal Government. What we're going to see in the next video is how that plays out in the yield curve.