Question

61. Explain the market segmentation theory of yield curve determination and how it relates to the supply and demand for loanable funds theory.

Answer 1

The market segmentation theory of yield curve determination:

• Is one of the three most popular theories of yiled curve determination
• States that bond markets are segmented as per the maturity of the bonds.
• The yields of the bonds with different maturity periods are determined independently of each other.
• The bonds with different maturities have separate markets called segments and
• This is because investors have preferences for financial instruments with particular terms to maturity
• If an investor has surplus cash idle for a longer period of time, he will prefer to buy a bond with longer maturity rather than investing in a shorter term bond, selling it and then reinvesting it, to avoid the transaction costs.

The market segmentation theory of yield curve determination implies that

• In each maturity segment, the bond yield is determined by the intersection of demand and supply for that type of bond.
• the shape of the yield curve is determined by the relative supply of and demand for bonds and other financial instruments of varying maturities.