1. Relationship between Yield Curve and Business Cycle
By:
Varsha Tushir (034)
Shilpa Deshwal (047)

2. The yield of a debt instrument is the overall rate of return available on the investment. For instance, a bank account that pays an interest rate of 4% per year has a 4% yield.
Yield Curve is the relation between the interest rate and the time to maturity of the debt for a given borrower in a given currency. 
A graphic line chart that shows interest rates at a specific point for all securities having equal risk, but different maturity dates .

3. Slope of an Yield Curve
The slope of the yield curve provides an important clue to the direction of future short-term interest rates; an upward sloping curve generally indicates that the financial markets expect higher future interest rates; a downward sloping curve indicates expectations of lower rates in the future

4. Business Cycle
Business cycle- is simply a means of describing the series of economic ups and downs that are part of the every business that operates over a number of years.
The four common expressions of the business cycle are the economic upturn, the economic peak, the economic decline, and the economic recovery.

5. Business Cycle

6. Stages in the Business Cycle
Economic upturn: is the most desirable phase, During this period, sales for the goods and services of the company are robust, with additional earnings posted from one period to the next.
Economic peak: During this cycle, the company is still profitable, but growth is minimal or non-existent.

7. Contd.
Economic decline: This cycle may occur due to the loss of customers to competitors, as a result of a recession that limits the disposable income of consumers, or marketing or expansion schemes that do not prove to be profitable for the company.
 Economic recovery: During this time business begins to overcome adverse circumstances that may have threatened the ongoing function of the enterprise. Profits begin to rise, laid off employees are called back to work.

8. some factors that shape business cycle
Volatility of investment spending
Technological innovation
Monetary policies
Fluctuations in exports and imports

9. Types of Yield Curve
Normal
Humped
Inverted
Flat

10. Normal Yield Curve
Normal yield curve- If short-term yields are lower than long-term yields (the line is sloping upwards), then the curve is referred to a positive (or "normal") yield curve.

11. Y is it Positive??
When the yield curve is positive- this indicates that investors require a higher rate of return for taking the added risk of lending money for a longer period of time. Many economists also believe that a steep positive curve indicates that investors expect strong future economic growth and higher future inflation (and thus higher interest rates).

12. Upward Sloping Yield Curve
Investors expect strong future economic growth and higher future inflation (and thus higher interest rates).

13. Flat and Humped yield Curve
Flat or humped yield curve-  flat yield curve is observed when all maturities have similar yields, whereas a humped curve results when short-term and long-term yields are equal and medium-term yields are higher than those of the short-term and long-term. A flat curve sends signals of uncertainty in the economy.

14. Humped yield curve

15. Flat Yield Curve
A flat curve generally indicates that investors are unsure about future economic growth and inflation.

16. Inverted Curve
Inverted yield curve - inverted yield curve occurs when long-term yields fall below short-term yields. Under unusual circumstances, long-term investors will settle for lower yields if they think the economy will slow or even decline in the future

17. Downward Sloping Yield Curve
Investors think the economy will slow or even decline in the future.

18. Characteristics of an Yield Curve
There are 3 characteristics of yield curve:
The change in yields of different term bonds tends to move in the same direction.
The yields on short-term bonds are more volatile than long-term bonds.
The yields on long-term bonds tend to be higher than short-term bonds.

19. The Expectations Hypothesis
This hypothesis assumes that the various maturities are perfect substitutes and suggests that the shape of the yield curve depends on investors expectations of future interest rates.
Rates on a long-term instrument are equal to the geometric mean of the yield on a series of short-term instruments.
This hypothesis assumes that the various maturities are perfect substitutes and suggests that the shape of the yield curve depends on market participants' expectations of future interest rates. These expected rates, along with an assumption that arbitrage opportunities will be minimal, is enough information to construct a complete yield curve. For example, if investors have an expectation of what 1-year interest rates will be next year, the 2-year interest rate can be calculated as the compounding of this year's interest rate by next year's interest rate. More generally, rates on a long-term instrument are equal to the geometric mean of the yield on a series of short-term instruments. This theory perfectly explains the observation that yields usually move together. However, it fails to explain the persistence in the shape of the yield curve.
Shortcomings of expectations theory: Neglects the risks inherent in investing in bonds (because forward rates are not perfect predictors of future rates). 1) Interest rate risk 2) Reinvestment rate risk2

20. Liquidity Premium Theory
The liquidity premium theory- explain the 3rd characteristic of the yield curve: that bonds with longer maturities tend to have higher yields. A longer term bond must pay a higher risk premium to compensate bondholder for the greater risk (inflation and interest risk ) ,
 Inflation risk reduces the real return of the bond. Interest rate risk is the risk that bond prices will drop if interest rates rise, since there is an inverse relationship between bond prices and interest rates.
 include a premium for holding long-term bonds (investors prefer short term bonds to long term bonds), called the term premium or the liquidity premium. This premium compensates investors for the added risk of having their money tied up for a longer period, including the greater price uncertainty. Because of the term premium, long-term bond yields tend to be higher than short-term yields, and the yield curve slopes upward. Long term yields are also higher not just because of the liquidity premium, but also because of the risk premium added by the risk of default from holding a security over the long term. The market expectations hypothesis is combined with the liquidity preference theory