A downward-sloping yield curve is evidence

a. both the preferred habitat and liquidity premium theories of the yield curve, because the expectations theory suggests it is always perfectly flat.

b. for none of the theories unless we have more information about what short term interest rates are expected to be in the future.

c. for the expectations theory of the yield curve because it is the only theory that accounts for a downward sloping yield curve.

d. for the preferred habitat theory of the yield curve because none of the other theories are consistent with this observation.

The answer is option B.

A downward sloping yield curve is evident of none of the theories unless we are aware of what the short term future rates are about to be in the future.

This is because in liquidity premium theory the future rates provide an estimate of market future rates that is biased in nature and also includes a liquidity premium.

When the short term market future rates are about to increase the yield curve is positive or upward sloping and when the future market rates are about to decrease then the yield curve is negative or downward sloping.

Hence, it is difficult to predict without knowing the short term future rates about the downward sloping yield curve in liquidity premium theory.

In the preffered habitat theory there exists a mismatch between the demand and supply of funds which leads to the inducement of lenders and borrowers from their preffered habitats the yield for which is not directly related to their time to maturity.

Hence, preffered habitat theory is not evident of the downward sloping yield curve.