The Preferred Habitat Theory is one of the many theories that are connected with the yield curves. The Preferred Habitat Theory tries to define the way the maturity period of a debt instrument and its yield are related.
The Preferred Habitat Theory is capable of describing the main reasons that are there behind the predominance of the normal yield curve. This theory also deals with the propensity of the yield curve to maintain its shape while moving down or up.
Description of Preferred Habitat Theory
The Preferred Habitat Theory could be described as a partial expectations theory. According to this theory the risk premium of a debt instrument need not be directly proportional to its maturity period.
Nature of Preferred Habitat Theory
The Preferred Habitat Theory could be said to have taken up a balanced stance vis-a-vis the explanation of the connection of a debt instrument’s term period and its yield. With regard to the explanation offered by the Preferred Habitat Theory it could be said that this theory is positioned between the Market Expectations Theory and the Market Segmentation Theory.
Contention of Preferred Habitat Theory
As per the Preferred Habitat Theory the investors want a proper premium to be paid to them when they are purchasing a debt instrument. This is an addition to the interest rate requirements and proper investment options they have. However, all these happen when the investors are putting their money in a debt instrument they are not habituated with.
According to the advocates of the Preferred Habitat Theory, in the fixed income markets the investors are putting their money more in the short-term debt instruments rather than the long-term debt instruments. However, the opposite may be true as well.
Last Updated on : 1st July 2013