In what way is the preferred habitat theory of the term structure of interest rates a combination of and an improvement over the other two theories of term structure of interest rates?

In what way is the preferred habitat theory of the term structure of interest rates a combination of and an improvement over the other two theories of term structure of interest rates? 

Ans. According to the Preferred Habitat Hypothesis the interest rate on a long-term bond equals the average of short-term rates expected to occur over the lifetime of the long-term bond plus a risk premium due to higher market risk in the long-term bond. 

Key assumption 

Bonds of different maturities are close substitutes but not perfect substitutes. 

Major non-price difference -- longer term bonds have higher market risk. 

Assessment: Preferred Habitat Hypothesis 

The downward sloping (inverted) yield curve is unusual but not rare.Accurately predicts occurrence. (Investors must expect interest rates to decrease a lot in the future.) 

Interest rates of bonds of all maturities move together (are positively correlated) Accurately predicts this occurrence. (Close substitutes) The downward sloping (inverted) yield curve tends to occur when interest rates in general are high. 

Accurately predicts occurrence 

Hence, it combines the preferred habitat theory of the term structure of interest rates a combination of and an improvement over the other two theories of term structure of interest rates.