In our previous discussions of both the expectations theory and the market segmentation theory we noted that both fail to explain some observed phenomena in the market satisfactorily. The preferred habitat theory is a combination, a synthesis of the those two theories created in order to explain the interest rate- maturity term relationship.

The preferred habitat theory posits that although investors prefer a certain segment of the market in their transactions based on term structure (the yield-maturity plot of the debt instrument showing which yield matches which maturity, another term for the yield curve) and risk, they are often prepared to step out of this desired to segment if they are adequately compensated for the decision. But they will never prefer a long term instrument over a short term contract with the same interest rate. Thus, maturity structure does lead to some fundamental differences in investor behavior, but there is always a price at which all maturities will provide the same attractiveness to a potential investor. In other words, a sufficiently high interest rate will lead market actors to attach greater value to a less-preferred, unusual maturity, leading to the usual upward sloping shape of the yield curve. The market is segmented, but only partially so, interest rates do add up over longer maturities, but once again, only in part.

The major conclusions of the preferred habitat theory are as follows:

1. 1.If the yield curve slopes upward, investors do not expect any major changes in interest rates. Rates may go higher, but they may also remain the same, with the upward slope reflecting the risk premium. In other words, the prevailing conditions are expected to continue (provided that the economy is growing).
2. If the yield curve is sloping downward, short interest rates are expected to fall. Since at higher maturities we'd expect interest rates to be higher, but get them lower in a downward slope, the only possible conclusion is that rates will fall so much that they will be lower than today's rates even with the risk premium added.
3. If the yield curve is flat, the market is expecting future rates to come down slightly. Interest rates must fall in the future, so that the yield curve may remain falt even with the risk premium added on top of future prices.

The preferred habitat theory is the modern interest rate theory explaining the yield curve. It was developed in the post-Nixon era to meet the difficulties arising in the fiat currency systems, and remains a valid tool today.

Next: How to make use of the yield curve in trading forex?

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