Segmented Market Theory

5.2.1.2 Segmented Market Theory

 This theory is at the opposite extreme to the expectations theory.

 Assumptions in this theory:

o Long-term and short-term securities are imperfect substitutes (traded in different markets)

o The forces of demand supply in separate markets (long and short-term) will determine the shape of the yield curves.

 Bonds of different maturities are said to be imperfect substitutes because investors have strong preferences for bonds of one maturity but not for another so they will be concerned with the expected returns only for bonds of the maturity they prefer.

 For example, short-horizon investors such as commercial banks whose major liabilities consist of short-term deposits would prefer securities with short-term maturities. On the other hand, long-horizon investors, such as insurance companies and pension funds whose liabilities have longer maturities, would prefer securities with long-term maturities.

 If investors prefer bonds with shorter maturities that have less interest-rate risk, the theory can explain fact 3 that yield curves typically slope upward (because demand for short-term bonds will increase, raises the price, and reduce interest rate for short-term bonds while demand for long-term bonds will reduce, decrease the price, and raises the interest rates).

 Fact 1 and 3 cannot be explained because of the assumption of imperfect substitutes, that is, there is no relationship or influence between short and long-term bond markets.

 An ascending yield shape implies that investors have a preference for short-term securities.

 A descending yield shape implies that investors have a preference for long-term securities.

 A