Updated July 10, 2023
What is Segmented Market Theory?
The segmented market theory asserts that short-term interest rates differ significantly from long-term interest rates, emphasizing that one should not utilize the behavior of one to predict the behavior of the other.
In other words, it might be wrong to predict a change in the long-term interest rates because of a certain change in the short-term interest rates. Hence, short-term and long-term interest rates should be analyzed independently. That is why the yield curves separately reflect the market demand and supply for Treasury bonds of different maturity periods.
Explanation
Segmented market theory suggests that long-term and short-term interest rates are completely unrelated to each other because both have different sets of investors. The preparation of yield curves is based on the demand and supply within each category of debt security maturities, indicating that one category cannot use another category to forecast the yield.
Example of Segmented Market Theory
Let us take the example of 5-year, 10-year, and 30-year US Treasury bond rates plotted in the chart below. On comparing the different yield curves, it can be seen that usually, there is a gap between the yields of the different debt categories. However, the size of the gap varies quite a bit over time. In other words, the spread between a 5-year and a 10-year bond or between a 10-year and a 30-year bond doesn’t remain constant over time. Hence, it might be wrong to predict the interest rates of one set of debt securities with a certain maturity period with the help of another set of debt securities with a different maturity period. Each debt category follows different demand and supply dynamics per segmented market theory.
Source: FRED
Banks and pension funds can further explain the above statement. Due to the fractional reserve system, banks need to maintain a certain level of liquidity, and hence the banks tend to participate in purchasing and selling short-term bonds. On the other hand, pension funds require stable income for a long period, and hence pension funds tend to participate in purchasing and selling long-term bonds. Here we see that these two financial institutions participate in the same bond market but with different maturity periods. So, banks would influence the demand and supply of short-term interest rates, while pension funds would influence long-term interest rates.
Implications of Segmented Market Theory
As explained in the previous section, the segmented market theory states that the buyers and sellers of the short-term securities market exhibit different characteristics and motivations compared to the middle and long-term securities markets. Therefore, the yield curve is one of the outcomes of the segmented market theory. Researchers draw yield curves for bonds with different maturity periods to study the relationship between long-term and short-term interest rates. However, supporters believe that exploring the yield relationship between long-term and short-term interest rates is futile as the short-term interest rates do not indicate the long-term interest rates.
Breaking Down Segmented Market Theory
The segmented market theory states that heterogeneous agents with different income needs comprise the bond market. All these agents invest in different bond market categories (based on maturity period) based on their income needs. Further, the hypothesis also states that short-term and long-term securities are fundamentally different, so they shouldn’t be placed in the same asset class. Typically, the decision to invest in long-term securities involves a greater number of factors as compared to that of short-term securities.
Advantages of Segmented Market Theory
Some of the major advantages are as follows:
- The theory advocates that the yield of securities of a particular maturity period primarily depends on the demand and supply of the buyers and sellers of that particular category. This is in line with the law of economics, which states that the price of a commodity is determined by its demand and supply in the market.
- The theory is based on the assumption of proper asset-liability management, wherein the market players hedge their liabilities for a certain period with investments of the same period. Otherwise, the investors would be exposed to the risk of changing interest rates during rollovers.
Disadvantages of Segmented Market Theory
Some of the major disadvantages are as follows:
- The market players usually don’t stick to a particular investment category. Instead, they tend to switch investment categories based on available opportunities. If they are offered a higher yield in any other category, they tend to move to that category.
- The whole theory assumes that the market players don’t change their investment preferences, which is not very true.
Conclusion
So, it can be seen that segmented market theory asserts a very important concept that the yield of securities of a certain maturity period can only be determined by the demand and supply of securities of that particular maturity period. However, one of the biggest limitations of the theory is that it is based on hard assumptions that are difficult to apply in the real world.
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