Chartered Financial Analyst (CFA) Practice Exam Level 2

What is the main investment preference described by Preferred Habitat Theory?

1. Investors prefer low-risk bonds

2. Investors prefer bonds of specific maturity that match assets and liabilities

3. Investors focus on high yield regardless of maturity

4. Investors avoid bonds with high volatility

The correct answer is: Investors prefer bonds of specific maturity that match assets and liabilities

The main investment preference described by Preferred Habitat Theory focuses on the idea that investors have specific maturity preferences based on their asset-liability management needs. According to this theory, investors are not solely driven by their desire to maximize returns or minimize risk in a general sense but instead have particular maturities that they prefer to invest in. This preference is largely influenced by the need to match the timing of their cash flows, such as future liabilities, with the maturity of their investments. In this framework, such preferences lead to a segmented bond market where certain maturities may trade at higher or lower yields based on demand from different investors. For example, an insurance company with liabilities that will come due in ten years has a strong preference for bonds that mature around that timeframe. This behavior results in varying yields across different maturities, as investors might be willing to accept lower yields on bonds that match their preferred maturity. Understanding this theory helps to appreciate how the bond market operates beyond just risk and return dynamics, emphasizing a more nuanced interpretation based on maturity alignment with specific investment needs.