What Is Market Segmentation Theory?
Let me explain to you what market segmentation theory is. It's a concept that says long-term and short-term interest rates aren't connected to each other. It also means you should look at the interest rates for short, intermediate, and long-term bonds as if they're in completely different markets for debt securities.
Key Takeaways
Here's what you need to know: Market segmentation theory holds that long- and short-term interest rates aren't related because they attract different investors. There's also the preferred habitat theory, which is connected to this; it says investors like to stay in their own bond maturity range for the guaranteed yields, and switching to another range feels risky to them.
Understanding Market Segmentation Theory
The main points of this theory are that yield curves come from supply and demand in each specific category of debt security maturities, and you can't use yields from one category to predict another. Market segmentation theory, also called segmented markets theory, assumes that each segment of bond maturities has its own market, mostly made up of investors who prefer certain durations: short, intermediate, or long-term.
It goes further by saying that the buyers and sellers in the short-term securities market have different traits and reasons compared to those in intermediate or long-term markets. This draws partly from how institutional investors behave—banks usually go for short-term securities, while insurance companies prefer long-term ones.
A Reluctance to Change Categories
Building on market segmentation theory, there's the preferred habitat theory. It states that investors have favored ranges for bond maturities and only move away if they're promised higher yields. Even if there's no real difference in market risk, someone used to a certain maturity category often sees switching as a risk.
Implications for Market Analysis
The yield curve directly stems from market segmentation theory. Normally, we draw the yield curve across all maturity lengths to show the link between short-term and long-term rates. But if you follow this theory, trying to analyze a traditional yield curve that covers everything is pointless because short-term rates don't tell you anything about long-term rates.
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