Question

Explain Interest Rate Market Segmentation Theory and give an example of it?

Answer 1

Market Segmentation Theory states that long and short term interest rates are not dependent on each other rather bond interest rates are affected by supply and demand in the market. So, we cannot compare yields of securities having different maturity lengths neither we can use them for bond yield prediction. In essence interest rates of long-, medium-, short-term bonds should be treated as they are securities in different markets.

In general, people/organisations buy bonds of different maturity age based on their investment goals and characteristics. For example,  insurance companies focus on maximizing their income so they buy long-term bonds whereas banks look for minimum volatility and high liquidity so they invest in short-term bonds.

The chart below compares 2 year and 5 year US Treasury yields. Over the time, the size of the gap between these two yields has been varying so we cannot deduct any correlation here.

2 Year Treasury Rate 5 Year Treasury Rate 2.25% 1.93% 1.75% 1.27% 0.75% 0.25% 2013 2014 2015 2016 2017