This is the fourth article in our series on interest rate theories. Read the first part here.
The third approach that we’ll discuss in this article is radically different from the two previous ones that we’ve examined. Both the liquidity preference theory, and the pure expectations theory depend strongly on the presumption that debt instruments of different maturities are only distinguished by their return, and that purchasing a two-year bond is essentially equivalent to buying two one year bonds in succession, since the market efficiently predicts future rates in the time horizon in question. Market segmentation theory (MST) does away with this approximation (since we all know that future rates as predicted by bonds and realized in the spot market do not exactly match each other), and discusses each separate maturity term as being independent of the others. In other words, we should not speak of a bond market, but rather of two-year, five-year, ten-year bond markets, since the roles played by these instruments are not equivalent in any way. Each maturity term is fulfilling a different function, with a different investor profile, and thus is a unique product, far from being a tool of convenience for those who would prefer to hold a single contract instead of renewing each short term one in succession, as suggested by the expectations theory.
MST posits that each borrower and lender have a particular timeframe in mind when purchasing or selling a debt instrument. An investment bank may be buying or selling a government bond in the short term in order to profit from interest rate changes that could be announced by a central bank. A construction firm may desire to sell ten-year bonds in order to repay them when the construction project is finished and there is abundant liquidity to meet the demands of the creditor. Similarly, a student would prefer to borrow on a long-term basis in order to meet his obligations after graduation, when he’ll have ample financial capability to pay his debts.
The market segmentation theory allows us to incorporate the depth of the market into our understanding of the term structure of debt instruments, and in a way, takes the two-dimensional LPT or the expectations theories, and gives them the third dimension of investor preferences. Thus, the risk premium discussed in the context of the liquidity preference theory is not just something demanded by the lender (supply side), but also eagerly provided by the borrower (the demand side) due to his preference for longer term maturities which allow better returns on investments as a result of the greater freedom enjoyed in business decisions and planning (you can plan for the longer term since repayment is a long way away from now). A greater number of lenders cluster around the short-side of the yield curve due to lower risk and higher liquidity, leading to lower yields, while a greater number of borrowers tend to group at longer maturities, due to the greater flexibility that they enjoy while making use of the funds, which leads to greater demand for borrowing, and higher rates, as a consequence. This supply demand segmentation of the market leads to the observed slope of the yield curve where the shorter term maturities are coupled to lower rates most of the time.
The advantage of this theory is that it succeeds where the other two theories fail. It can easily explain while the yield curve slopes upwards most of the time, but does not say anything about why rates move up or down simultaneously across the maturity scale. Since each maturity term constitutes a separate market, we would expect their interest rates to move independently up or down, with no obvious relationship, but that, of course, contradicts the well-known and easily observed relationships in the market.
To combine the market segmentation theory with the better aspects of the liquidity preference theory, the preferred habitat theory was developed, which we’ll examine in the next chapter.
Next, part 5 >> Preferred Habitat Theory >>
Previous, part 3 << Liquidity Preference Theory <<
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