Market Segmentation Theory is a modern theory pertaining to interest rates stipulating that there is no necessary relationship between long and short-term interest rates & and that investors have fixed maturity preferences. It is also called segmented markets theory. Supporters of Market Segmentation Theory maintain that short-term and long-term rates are distinct markets, each with its own buyers and sellers, and are not easily substituted for each other
Overview of Market Segmentation Theory
The Market Segmentation Theory is one of the various theories that are associated with the yield curve. It is also known as the segmented market hypothesis. The Market Segmentation Theory tries to describe the relation of the yield of a debt instrument with its maturity period. The Market Segmentation Theory explicates the reasons behind the prominence of normal yield curves over the other forms of yield curves Furthermore, short and long-term markets fall into two different categories. Therefore, the yield curve is shaped according to the supply and demand of securities within each maturity length.
The Market segmentation theory states that most investors have set preferences regarding the length of maturities that they will invest in. Market segmentation theory maintains that the buyers and sellers in each of the different maturity lengths cannot be easily substituted for each other. An offshoot to this theory is that if an investor chooses to invest outside their term of preference, they must be compensated for taking on that additional risk. This is known as the Preferred Habitat Theory.
In the Market segmentation theory, it is assumed that short term and long term rates are determined in separate or segmented markets. Some investors prefer short term securities. They invest in short term bonds.Again, there are some investors who prefer long term bonds. As a result bonds having different maturity periods are not perfect substitutes for one another. Such an argument implies that lenders and borrowers are interested in bonds of only one maturity and even if the return on a sequence of shorter bonds were considerably higher than the return on those bonds, they would not attempt to switch into shorter bonds. Therefore, expectation concerning short rates would have no role in determining long rates. Thus even if short term rate increases in any period of time this theory implies that investors will not shift from long term bonds to short term bonds in order to enjoy higher rate in the short run. Thus even if the short run rate of interest increases it will not influence the long term rate of interest.
Market segmentation theory is based on institutional practices followed by the commercial banks and insurance companies and investment trusts. While the commercial banks mostly deal in short term securities, insurance companies and investment trusts mostly deal in long term securities. Market segmentation theory is however not free from defect as it overlooks the fact that there is considerable degree of overlapping between different markets. Same institutions operate in different markets dealing in securities of different maturities.
Contention of Market Segmentation Theory
According to the Market Segmentation Theory the financial instruments that have separate term periods cannot be replaced with one another. This means that the demand as well as supply of debt instruments having long term periods and short term periods in the financial markets is ascertained separately.
Choices of Investors
The choices of investors are an important part of the Market Segmentation Theory. According to this theory the investors need to make their choices beforehand. It has been seen that the investors normally want to invest in debt instruments that have shorter term periods. The main reason behind this is that the investors like to have investment portfolios that have a certain amount of liquidity. The short term debt instruments provide them with that luxury. Thus according to the Market Segmentation Theory, the financial market that deals in debt instruments of shorter terms would experience more demand. As per the Market Segmentation Theory if a particular debt instrument has higher demand it is supposed to cost more. The yield from the same would be relatively low. The fact that the yields of short-term debt instruments are lower than that of the long-term debt instruments could be understood from this explanation.
Market Segmentation Theory Facts
In the United States of America the yield curve of the dollar was reversed in the later stages of 2005 and early period of 2006. The yields of the short-term debt instruments were more than that of the long-term debt instruments. This could be explained by the Market Segmentation Theory. As per the Market Segmentation Theory the investors might have preferred the long term debt instruments over the short term debt instruments and this could have contributed to the higher yields of short-term debt instruments over long-term debt instruments.