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FRM Part I · FRM Exam Part I · Properties of Interest Rates

Which observation about forward rates is most consistent with the preferred habitat theory?

Preferred habitat theory says investors favor certain maturities but will move to others if compensated with enough extra expected return, so term premiums can be positive or negative and vary by maturity. This differs from strict segmentation, pure expectations, and the always-positive premium of liquidity preference.

  1. AInvestors never leave their maturity sector regardless of yield differentials.
  2. BForward rates equal expected future spot rates with no premium.
  3. CInvestors will shift away from their preferred maturity if offered a sufficiently higher expected return, so premiums may be positive or negative across maturities.Correct
  4. DTerm premiums are always positive and increase with maturity.

Explanation

Preferred habitat combines expectations with segmentation: investors have maturity preferences but will move for adequate compensation, so premiums can differ in sign and size. Option A is segmentation, B is pure expectations, and D is the simple liquidity preference view.

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