There are many theories associated with the yield curve and one such theory is market segmentation theory. It brings together potential buyers into segments with common needs, that will respond to a marketing action.
This means that, certain investors are interested in particular types of investments like short-term debt securities. However, few investors are interested in only long-term bonds. Thus, it discusses each separate maturity as independent from others.
What is it?
It shows that there is no direct relationship between the prevailing interest rates in the market in both, the short-term and long-term markets. Both these plans have separate term periods, that cannot be replaced among each other. So the demand and supply of debt instruments with both the periods are calculated individually.
The theory finds that, the securities that are traded in short-term market may undergo a significant flux, and the rates that are applied to long-term investments remain static to some extent. It is sometimes also known as the segmented markets theory. It mostly agrees and supports the preferred habitat theory.
According to the preferred habitat theory, the investors have a specific expectation, when one is required to invest in securities with different maturity lengths. When an investor trades on an opportunity, that matches their preferences and their assumed degree of risk, the expectations remain within the degree of reason.
However, if he buys or sells securities that have a maturity beyond their preferences, it will affect their assumption of risks and needs, and will require a need for increased return to balance that risk.
Those who advocate this theory have pointed out that, the evaluation of the yield curves of short-term and long-term markets, shows that the rate of interest applied has little or no relationship with one another. In fact, the yield curve is based on the available supply and demand of options, and not on interest rates.
The investors choice is one of the most important part of this theory. It is seen that, investors make their choices in advance and normally want to invest in debt instruments with short-term periods.
This is because, they want to have some amount of liquidity and short-term investments give them it. Thus, in the finance market, the debt instruments that have more demands are short-term investments.
It also states that, if there is more demand for a particular investment, it will definitely cost more. However, the yield will be very low. Thus, one can understand why short-term yields are lower than those with its counterpart.
It is also seen that, when short-term rate increases during any period of time, the investors will not shift from long-term bonds to short-term bonds. Therefore, increase in the rate of yield will not influence investors of long-term investments.
The theory is based on the practices of commercial banks, insurance companies, and investment trusts. Commercial banks are institutions that mostly deal with the short-term investments and insurance companies and investment trusts indulge in long-term investments.
However, there are chances of overlapping between the different types of markets, and some short-term institutions deal in various markets that offer different securities with varying maturities.
The market segmentation theory has its own advocates as well as critics. Some investors execute investment that involve both short as well as long-term maturities.
These investors do not believe that, these two different investment markets function as independents, especially in case of interest rates. They focus on the short-term market and influence the long-term market gains and vice versa.