InvestorQ : What is the basic premise of the market segmentation theory and how to apply the same?
Niraja Mehta made post

What is the basic premise of the market segmentation theory and how to apply the same?

Answer
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Mary Joseph answered.
1 year ago


Under the Market Segmentation Theory, rates are determined by supply and demand conditions in each maturity range of the yield curve. For example, 30-year rates are influenced by the supply and demand for mortgages. This theory assumes that the yield curve is not a single curve but dividend into short term, medium term and long term. The assumption here is also that the dynamics and the economics of each of these three sub segments are different and it is the key to understanding the yield curve.

According to this theory, investors have a strong preference for a specific maturity and would require a premium to invest in other bonds with different maturities. As a result, there can be a risk premium for different maturities along the yield curve, but they do not necessarily increase with maturity as they do under the Liquidity Premium Theory. As a result, the yield curve may not rise or fall continuously.