How does market segmentation theory work?
Market segmentation theory holds that long-term and short-term interest rates are unrelated. It also argues that the current interest rates for short-, intermediate-, and long-term bonds should be assessed individually as if they were items in different debt securities markets.
Understanding the Theory of Market Segmentation
The main implications of this theory are that yield curves are determined by supply and demand dynamics within each market or category of debt security maturities and that yields for one category of maturities cannot be used to anticipate yields for another.
The segmented market theory is another name for market segmentation theory. It is based on the assumption that the market for each bond maturity segment mainly comprises investors who want to invest in securities with specified durations: short, intermediate, or long-term.
According to market segmentation theory, buyers and sellers in the market for short-term securities have distinct traits and motivations than buyers and sellers in the market for intermediate and long-term maturity assets. The hypothesis is partly based on the investment practices of various institutional investors, such as banks and insurance firms. Banks prefer short-term securities, but insurance firms prefer long-term securities.
Unwillingness to Change Categories
The preferred habitat theory is a similar idea that expands on the market segmentation hypothesis. According to the preferred habitat theory, investors have preferred ranges of bond maturity durations and will only deviate from their preferences if greater yields are assured. While there may be no discernible difference in market risk, an investor accustomed to investing in securities of a particular maturity category may view a category move as dangerous.
Market Analysis Implications
The yield curve is an outgrowth of market segmentation theory. The bond yield curve has traditionally been drawn throughout all maturity length categories, reflecting a yield relationship between short-term and long-term interest rates. However, proponents of market segmentation theory argue that evaluating a standard yield curve including all maturity lengths is futile because short-term rates are not indicative of long-term rates.
Conclusion
- According to market segmentation theory, long-term and short-term interest rates don’t affect each other because they appeal to different types of buyers.
- The chosen habitat theory is related to market segmentation theory. It says buyers like to stay in the maturity range of their bonds because they are sure to earn a certain amount of money. People see any change to a different age level as risky.
