If a one-year bond currently yields 5% and is expected to yield 7% next year, the preferred habitat theory predicts that the yield today on a two-year bond will be
A)5%.
B)less than 6%, but more than 5%.
C)6%.
D)more than 6%.

Question

Quizplus · Accepted Answer

The preferred habitat theory suggests that investors have a preferred holding period for bonds and will only change their preferred maturity if they are adequately compensated for the change. In this case, if the one-year bond currently yields 5% and is expected to yield 7% next year, investors will likely prefer to hold the one-year bond rather than the two-year bond. As a result, the yield on the two-year bond must be higher than 7% to entice investors to hold it. Therefore, the yield today on a two-year bond is expected to be more than 6%.

If a One-Year Bond Currently Yields 5% and Is Expected