TSIR: Preferred Habitat Theory

Question 1

State the preferred habitat theory?

Answer 1

• The return on bonds of a given maturity is determined by S&D of bonds in that market (always true), and investors will not switch between bonds of different maturities regardless of the expected return from doing so (unrealistic)

Question 2

Rationale of the PHT?

Answer 2

If buying a house and need a 20yr mortgage, don’t care about 30yr treasury bonds

Question 3

2 implications of PHT if it held?

Answer 3

a) Future short rates have no effect on long rate
b) Yield curve can be any shape, depending on D&S for that specific maturity, and therefore changing bond supply for any specific maturity will only affect bonds in that market (leaving others unaltered!)

Question 4

Why is the PHT unrealistic?

Answer 4

Because neither of its implications hold up empirically; they are both very unrealistic