This theory states that short term bonds are more favourable than long term bonds for 2 reasons.

i) Investors generally prefer short term bonds to long-term securities because such securities are more liquid in the sense that they can be converted to cash with little danger of loss of principal. Therefore – investors will accept lower yields on short term securities.

ii) At the same time borrowers react in exactly the opposite way.Generally borrowers prefer long term debt because short-term debt exposes them to the risk of having to repay the debt under adverse. Conditions, accordingly borrowers are willing to pay higher rate other things held constant for long-term process than short ones.

Taking together this two sets of preferences implies that under normal conditions, a positive maturity risk premium exist which increases with maturity thus the yield curve should be upward sloping. Lenders prefer liquidity (short term hands) while borrowers prefer long term bonds and are willing to pay a “premium” for long term borrowing.