Market Segmentation Theory
FNCE 4070
Financial Markets and Institutions
Market Segmentation Theory
• This theory states that the market for
different-maturity bonds is completely
separate and segmented.
• The interest rate for a bond with a given
maturity is determined by the supply and
demand for bonds in that segment with no
effect from the returns on bonds in other
segments.
MST
• We will consider the following market
structure:
– Two sectors – government bonds and corporate
bonds
– Two maturities – short-term and long-term
MST Demand
• Most important factors determining demand for shortterm (long-term) bonds are:
–
–
–
–
–
The interest rate on the bonds
Government policy
Wealth
Liquidity
Risk
• The demand for short-term (long-term) bonds in one
sector is inversely related to the demand in another
sector (corporates vs government) but is not related to
demand for the long-term (short-term) bonds in either
sector
MST Supply
• The supply for short-term and long-term corporate bonds
are related to their
– Price/interest rate
– General economic conditions
• Increasing in economic expansions
• Decreasing in recessions
• The supply of Treasury Bonds depends only on government
actions (monetary and fiscal policy)
• The supply of Treasury Bonds does not depend on the
economic state or interest rates
– The sale or purchase of treasury securities by the central bank
or the treasury is a policy decision
– This implies that the supply curve for Treasury bonds is vertical.
Market Segmentation Theory
Case 1: Economic Recession
• Suppose the economy moves from a period of
economic growth into a recession
– Business demand for short-term and long-term assets
teds to decrease.
– Thus business supply for short-term and long-term
bonds tends to decrease.
– Creates excess demand for corporate bonds
• Drives bond prices up and interest rates down.
– Increased demand for corporate bonds increases
demand for treasury bonds at existing yields
• Drives treasury bond prices up and government interest
rates down.
Case 2: Treasury Financing
• Interest rates on Treasuries depends, in part,
on the size and growth of the federal
government debt.
• If deficits are increasing over time then the
Treasury will be constantly trying to raise
funds in the markets
• The choice of securities affects the yield curve
for treasury bonds and by substitution the
yield curve for corporates.
Case 2: continued
• By choosing which securities to finance the
deficit with the federal government can push
short term rates upwards or long term rates
upwards.
• By substitution these actions will have a
similar effect on the corporate yield curve
Case 3 : Open Market Operations
• Expansionary OMO in which it buys shortterm securities will cause the yield curve to
become positively sloped
• Expansionary OMO in which it buys long-term
securities will cause the yield curve to become
negatively sloped
• Contractionary OMOs work in the opposite
direction
Preferred Habitat Theory
• Investors and borrowers have preferred
maturity segments.
• They may stray away from their desired
maturity segments if there are relatively
better rates to compensate them.