 In this section, we are going to talk about the preferred habitat theory. So, it has been observed that investors have a certain preference for a bond of a specific majority. So, we can say that there are distinct investors or the customers of bonds or the buyers of bonds can be categorized into different categories that there are certain people who prefer to invest in medium term investment opportunities. There are certain types of people who prefer to invest in short term bonds and there are certain types of people who prefer to invest in long term bonds or long term investment opportunities. But generally we can state that most of the people, it has been observed over the past so many years that most of the people being risk a worse prefer to invest in short term bonds. So, this is something which needs to be understood clearly and when we say that preferred habitat theory explains that there are individuals who have a certain preferred habitat. Means, they plan that they are going to invest in a specific bond with a specific maturity time. So, they cannot be switched from one market, one type of category to another unless and until a higher yield is offered to them. So, for example, we are saying that most of the people prefer to invest in short term bonds. If you want them to invest in medium term bonds or the long term bonds, then you will have to offer something at the top of what they can earn from investing in the short term bonds. So, in other words, we can say that, every investor has a preferred habitat. He thinks that he should invest in this kind of maturity bond only. And if you want to get him out of his preferred habitat and invest in another category, then you will have to offer a better package, higher yield. And we also learned from here that most of the investors prefer to invest in short term bonds because most of the people are risk-averse. They don't like to take big risks. There are very few people who are risk-lovers who like to invest in high-risk investment opportunities. Therefore, because most of the people are risk-averse and because they are risk-averse, they like to invest in short term bonds that are mature. So, if you want to invest in 5-year maturity bonds or in 10-20 years, then you will have to offer some additional higher yield. I am going to explain the concept of preferred habitat theory using this graph. So, as you can see that we have taken years to maturity over the X-axis and the interest rate or the yields along the vertical axis. So, as a benchmark or the base, we have drawn this horizontal straight line which explains the expectation theory. It means that what we are trying to say from this horizontal straight line is that whether the maturity is short term, whether a bond is going to be short term or in long term, the expectation theory says that the yield curve is going to be the same or it is a horizontal straight line. So, it means that the expected yield in the short term bond is more or less going to be the same as we are going to expect for the long term bond. So, the yield of the long term bond is almost equal to the yield of the short term bond. And if this happens, then we have a horizontal straight line. With the help of this horizontal straight line, I am going to explain you the yield curve of liquidity, premium, theory or preferred habitat. And what is in this is that we are trying to say that if you invest money on short term investment, for example, you are getting a certain 5% interest rate. But if you decide to invest in a bond which will mature in 5 years, you will like to buy an investor. The premium interest rate which should be increased by 5% in every situation. Because if this is the situation that he is intending to invest or you want him to invest in a long term bond which will mature in say 5 years, you will have to offer an additional higher yield or he expects to invest more time for his money that I will get a higher rate of return. And this vertical distance which is taking the difference from the yield curve of expectation theory to the liquidity premium theory. So this particular difference is called liquidity premium. This means that the investor wants to be compensated for being away from his money for 5 years. So to compensate for that, he needs a liquidity premium and we assume that it is 2%. Similarly, if somebody is saying that if we can explain this in the context of preferred habitat, that if someone's preferred habitat, an investor prefers to invest money in a bond which will mature in 2 years and he is expecting that the premium or interest rate which he will get is 6%. And if you want him to take out his preferred habitat and invest in a bond which will mature in 25 years, then you will have to offer a high interest rate of 6% so that he can be compensated for being away from his money for 25 years. So then it expects the liquidity premium and in this case for example if the preferred habitat for that investor was for example he was intending to invest it at 2 year maturity bond and he was expecting to come up with a yield of 6% here for 25 years he is investing so suppose we are expecting that instead of 6% he will be offering 12% yield and he will invest his money for 25 years. So liquidity premium theory is saying that it's not just the average of the short term bonds comparison with the long term yield, long term investment, long term bond which will yield along with that it's not just a match, the investor doesn't do it, he also expects the liquidity premium. So that is another important aspect from the perspective of the investors and from the perspective of the people who are making these packages different time periods of mature bonds. So preferred habitat theory to further explain, over here in this diagram I'm going to show you 4 different types of graphs. In this combination of graphs I'm going to discuss each and every graph in detail. The first thing I'm going to discuss with you is this panel A. Right over here again we have taken the term to maturity along the x-axis and the yield to maturity along the vertical axis. We can say that this particular yield curve is upward moving and he is telling you that the future term, short term interest rates that the investor expects if they increase, in that case the yield curves will be sloping upwards. But if the investor thinks or expects that short term interest rates won't increase very fast, more or less the yield curve will be the same but the rise is going to be not that big. In this case the yield curve will be something like this. You can compare that this is relatively less steeper as compared to this one. The steeper it is means that you expect the short term investment yield to increase in the future whereas here the yield curve is relatively flat. So we can see that there is an increase in the yield in the short term bonds over time in future but the yield this distance is relatively smaller as compared to this distance. So here expected increase is greater as compared to the expected increase in this case. So you can see from the steepness and flatness of the yield curve that the investor is looking at the yield increase over the short term bonds. In the third panel you can see that the yield curve is drawn as a horizontal straight line in which they think that in the future the short term yields are going to fall moderately or in this case you can see the horizontal straight line here. But if we look at this carefully this will be slightly going down. The fall is very low but this is not a horizontal straight line. On the contrary we have got this fourth panel in which the yield curve is seen to be inverted or sloping downwards that shows that in future the short term interest rates are expected to fall and the fall is going to be sharp means the yield of short term bonds is going to fall in future and this is what the investor is expecting. So these expectations have implications and as soon as the investor feels that in the future in short term investment the return is going to fall, it is going to increase, it will sharply rise it will gradually fall or it will gradually fall slowly. This has got implications on the investment. So the investment decisions are accordingly as soon as your expectations change.