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.
- The investors of different segments are different, and the interest rate in each segment is determined by the demand and supply of each segment. The interest rate prevailing in each segment is solely the function of supply and demands of funds for the particular maturity.
- Thus each maturity sector (Long Term, Short Term, and Mid Term) can be classified as different market segments where the yield has no correlationCorrelationCorrelation is a statistical measure between two variables that is defined as a change in one variable corresponding to a change in the other. It is calculated as (x(i)-mean(x))*(y(i)-mean(y)) / ((x(i)-mean(x))2 * (y(i)-mean(y))2. with other segments and is based purely on the supply and demand of that particular segment.
- The segmented market theory assumes that the participants in each segment are either not willing to shift their segment to search for greater yield or are unable to do so due to restrictions imposed.
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. model-driven by expectations” by Irving Fisher and came up with his theory.
- The interest rate in the market keeps on changing. Consider an insurance company. Life insurances are mainly long term. They may range from maturities of 20 to 40 years. So when an insurance company is selling insurance, then the company is exposed to long term liabilityOng Term LiabilityLong Term Liabilities, also known as Non-Current Liabilities, refer to a Company’s financial obligations that are due for over a year (from its operating cycle or the Balance Sheet Date). .
- So to off-set the liability, the company will have to invest in assets. As the liability is for the long term, so the asset that the company will invest will also be of the long term. So the company will invest in long-term bonds.
- The insurance companies will mostly invest in long term segment. They will not invest in short term bonds and again roll over after maturity as they will not take the risk of interest rate falling during rollovers. So there is no shift in segments. Investors are fixed in particular segments, and yield in the segment is determined by the demand and supply of that segment.
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.
- The bond yieldBond YieldThe bond yield formula evaluates the returns from investment in a given bond. It is calculated as the percentage of the annual coupon payment to the bond price. The annual coupon payment is depicted by multiplying the bond's face value with the coupon rate. of a particular segment will be completely determined by the demand and supply of investors and borrowers of the particular segment. So this is actually true in real life. As per the law of economics, prices are set by demand and supply
- Proper Asset liability managementAsset Liability ManagementAn asset/liability management is paying off liabilities from assets and cash flows of a company. Its proper implementation reduces the risk of loss for not paying the liabilities on time. Companies must ensure that assets and cash flows are available on time to avoid additional interest and penalties. can be done based on this theory as there is a complete hedge of liabilities of a particular segment by investing in that segment. If there were shifts allowed, then investors would have been exposed to interest rate risk during rollovers
- 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.
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.
This has been a Guide to What is Segmented Market Theory & its Definition. Here we discuss the history of segmented market theory, example, and assumption along with advantages and disadvantages. You can learn more about from the following articles –