Segmented Market Theory

What is Segmented Market Theory?

The segmented market theory states that the interest rate curve is actually differentiated in segments based on the bond maturity required by investors and each segment is independent to each other. So short term bond rates are not related to long term bonds and vice-versa and therefore, the yields of each segment are determined independently.

Explanation

Segmented Market Theory

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Source: Segmented Market Theory (wallstreetmojo.com)

History

The market segmentation theory concept came into existence in the year 1957 by a famous American Economist, John Mathew Culbertson. The theory was published in his paper called “The Term Structure of Interest Rates.” In his paper, he challenged the earlier known theory of “Term StructureTerm StructureThe term structure is the graphical representation that depicts the relationship between interest rates and various maturities. The graph itself is called a “yield curve.” The term structure of interest rates plays an essential part in any economy by predicting the future trajectory of rates.read more model-driven by expectations” by Irving Fisher and came up with his theory.

Example

Assumption of Segmented Market Theory

The primary assumption of the Segmented Market theory is that bonds of different maturities are not substituted for each other. It means if you play to invest for the long term, then you can’t buy a short term bond and rollover. You will have to buy long term bonds only. Shifting of the segment is not allowed.

Segmentation Market Theory vs. Preferred Habitat Theory

The Preferred Habitat theory is similar to segmentation theory in the belief that borrowers and lenders stick to a particular segment and prefer the segment strongly, but it doesn’t say that yields of each segment are totally independent and are not correlated at all. Preferred habitat states that if investors see they will be receiving more yield in other segments rather than their preferred segment, then they will move from their preferred segment. Shifting of segments is not allowed in Segmentation Theory.

Advantages

Disadvantages

  • Investors actually don’t stick to a particular segment. They change segments as per the opportunity. If they get better yield in any other segment, then they tend to shift segments.
  • The theory is based on a hard assumption that Investors can’t change their preferred habitat, which is not true in real life.

Conclusion

Segmented Markets theory highlights an important property that yield is set by demand and supply of the bonds of a particular segment. The yield offered by the bond is actually based on the demand and supply, and thus this theory is applicable in the real world. The hard assumptions are difficult to carry in the real world scenarios.

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