hi guys, a little confused about this theory:-( for example,how to explain a positive slope yield curve. According to preferred habitat theory,there should be excess short-term demand and excess long-term supply for funds,right? how does risk premuim required to entice investors out of their preferred habitats?? thanks a lot 
Preferred habitat is consistent with any yield curve shape. The theory says that both the future rates and risk premiums are reflected in the term structure, and so, unlike the liquidity theory, premiums relate to demand at different maturities. The second important point to take away from this is that traders can shift from their preferred habitats but they need to be compensated in order to do so. For example, if I want to borrow funds at a maturity that is not the preferred one, I can do so, but I’ll have to pay more to entice investors. It works for borrowers too. I can be enticed to borrow at a different term than I would prefer if I can do it cheap enough. My reading of it is that there does not have to be “excess” demand for any term. T/G
thants u T/G here is my question again, PH theroy supposes to explain any shape of yield curve, for example ,a positive slope one, then how to make short term yield less than long term yield according to PH theroy??
If short term yields are preferred then they will yield less than long term yields. Just supply and demand at different maturities. However the theory seems to be consistent with an equal preference for short and long and the curve shape reflects future rate expectations. T/G
trader is right a normal yield curve would imply that short terms are preferred vs long terms that would mean 2 things 1. short term rates would be lower 2. there must be a premium for the longer term in order to create incentive for long term.
still a little confused,whats wrong with me??
as for normal yield curve, theres high demands for funds in short term, how does this high demand for funds push interest lower then?
still a little confused,whats wrong with me?? as for normal yield curve, theres high demands for funds in short term, how does this high demand for funds push interest rate lower then?
As prices are bid up the YTM goes down. You are going to get back 1000 for a bond no matter what, so the higher the price goes the lower your return. Disclaimer: I didn’t read the whole thread.
ill take a shot… say if i am a cash/ liquid fund. The pref habitat would be shorter duration papers. However if the spread widens between ST & LT papers, i may go for the LT papers as they now are giving me a higher return. Vice versa, if the spread narrows, an income fund may find that on a risk adjusted basis the ST papers make more sense and may increase the weights of St funds in their Portfolio( though their pref habitat here would be Lt papers) so depending on the spread the demand for ST or LT explains any kind of yield curve…
Will someone refresh me on the various theories quickly for the yield curve, just listing names will do.
pure expection theory liquidity theory preferred habitat theory