Preferred Habitat Theory and Liquidity preference Theory

Preferred Habitat Theory

This theory rejects the assertion that risk premium must increase uniformly with maturity. This theory is explained in terms of time-bucket preferences of investors. The investors who participate in bond market have different preferences in terms of maturities depending upon their liability profile. For example, Insurance companies and pension funds have long term liabilities and they prefer to invest in bonds with relatively higher maturities. Banks and mutual funds have short term liabilities, so they go for short-term bonds. These distinct investment horizons create different levels of demand and supply in different time buckets. Higher the demand for bonds in a particular time bucket, higher the price and lower the yield.

Liquidity Preference Theory

This theory explains the difference of interest rates for short term and long term bonds in terms of liquidity preferences. This is a combination of hypothesis theory and preferred habitat theory. Liquidity preference theory says that shorter the maturity lesser the volatility of interest rates and less risky. Because of less involved risk ,short term bonds are more liquid compared to long-term bonds.