THEORY OF TERM

STRUCTURE OF INTEREST
RATE
GROUP 3
Market Segmentation theory

Assumption: Securities with different maturities are not substitutes

at all.

Implication: Market rates are completely segmented; interest rates

at each maturities determined separately.

Market participants have strong preferences for securities of

particular maturity and buy and sell securities consistent with their
maturity preferences.
Contd.

As a result, the shape of yield curve is a result of supply and

demand for securities at or near a particular maturity, and thus the
curve is segmented.

Interest rate for each security with a different maturity is

determined by the demand for and supply of that security.

If investors generally prefer bonds with shorter maturities that have

less interest-rate risk, then this explains why yield curves usually
slope upward.

For example
If more borrower wants to borrow long term debt than investors wants
to invest long term, then interest rates for long term funds will go
up.