Chartered Financial Analyst (CFA) Practice Exam Level 2

According to the theory of preferred habitat, what are investors willing to do?

1. Invest only in bonds they know

2. Buy bonds of different maturities only for higher expected returns

3. Invest in very short-term bonds only

4. Repurchase bonds before maturity

The correct answer is: Buy bonds of different maturities only for higher expected returns

The theory of preferred habitat suggests that investors have specific maturity preferences based on their individual investment strategies and needs, but they are also willing to deviate from these preferences if they are compensated with higher expected returns. This means that while investors might prefer to invest in bonds with certain maturities, they are not strictly confined to those preferences. Instead, they will purchase bonds of different maturities if the yield on those bonds, which corresponds to a different maturity than their preferred one, is attractive enough to compensate for the additional risks or changes in strategy involved in such a decision. This concept highlights the flexibility of investor behavior in response to market conditions. Investors look for the best risk-adjusted returns, which can lead them to buy bonds that do not match their preferred habitat if it provides a more compelling return.