What is Market Segmentation Theory?

The market segmentation theory is the assumption that both short-term and long-term interest rates have no correlation whatsoever. In addition, the theory states that the interest rates for each different maturity segment vary. Note that this depends on demand and supply as well as demand and risk related to security.

How Does Market Segmentation Theory Work?

According to this theory, behaviors are analyzed separately. This, therefore, means that a change in one behavior does not in any way cause the other to change. Basically, market segmentation theory assumes that each of the bond maturities market segments is mainly made of investors, who, in this case, prefer to invest in securities that have specific durations such as short-term, long-term or intermediate. In addition, the theory asserts that buyers and sellers who make up short-term securities market have distinct features and motivations compared to buyers and sellers of long-term as well as intermediate maturity securities. The theory partly applies to various types of institutional investors and their investment behaviors. Such institutions include insurance and banking institutions. Note that when it comes to securities, banks prefer investing in short-term securities while insurance institutions prefer to invest in securities that are long-term. Generally, when it comes to investing in fixed-income securities, this theory holds that there is a preference for particular yields among borrowers and investors. It is this preference that causes the smaller markets each to have supply and demand that is unique to each other. Since each yield is as a result of factors related to demand and supply depending on each maturity length, it makes bonds with different maturities not be interchangeable. 

History Behind Market Segmentation Theory 

Market segmentation theory was first introduced in 1957 by John Mathew Culbertson an American economist. Culbertson wrote the paper known as, The Term Structure of Interest Rates, where he disagreed with Irving Fishers term structures model-driven expectations, which prompted him to come up with his own theory to explain how the market sets a price on fixed income securities.

Market Segmentation Theory vs. Preferred Habitat Theory

Preferred habitat theory is a theory that tells more about market segmentation theory. For instance, the preferred habitat theory argues that investors that have a preference on bonds with different range of maturity lengths, usually change their preferences when they are certain that by shifting, they will in return get higher yields. 

Key Takeaways

• The market segmentation theory is the assumption that both short-term and long-term interest rates have no correlation whatsoever.
• Market segmentation theory was first introduced back in 1957, by John Mathew Culbertson an American economist.
• Preferred habitat theory is a theory that tells more about market segmentation theory.