What is the Market Segmentation Theory?

The market segmentation theory is a contemporary concept that states there is no direct relationship between the interest rates that prevail within short-term and long-term markets. Instead, the theory is that these two markets are distinct, and the interest rates will respond to whatever is occurring in the market where the options are traded. According to the essentials of the market segmentation theory, securities traded in a short-term market may be undergoing significant flux while the rates applied to long-term investments may remain somewhat static.

Sometimes referred to as the segmented markets theory, the market segmentation theory is often considered to agree with and support what is known as the preferred habitat theory. This theory states that investors have very specific expectations when it comes to investing in securities with different lengths of maturity. As long as investors focus their trading activity on opportunities that comply with their preferences, those expectations remain within reason, including the degree of risk that the investor assumes. Should the investor choose to buy and sell securities that carry a maturity outside their preferences or habitat, this will impact the amount of risk he or she assumes, and require an expectation of increased return to offset that risk.

Proponents of the market segmentation theory note that evaluating the yield curves of short-term and long-term markets often reveals that the rates of interest that apply seem to demonstrate little to no relationship to one another. Here, the yield curve associated with the market is found to be based more on the available supply of options, and the demand for them, and less on interest rates. At the same time, investors looking for a quick return are more likely to focus their attention on opportunities with a short maturity, while those looking for investments to hold over a longer period of time will be attracted to the long-term market. Since the focus is on when the return will be realized, and not the interest that applies to investments with vastly different lengths of maturity, the theory appears to work well in a number of situations.

While there are proponents of the market segmentation theory, not everyone agrees on the degree of veracity of the theory. Investors who routinely execute investment transactions involving short-term as well as long-term maturities do not necessarily believe that these two markets function independently of one another, especially when it comes to interest rates. Instead, the understanding is that there is at least the potential of the short-term market to influence rates in the long-term market, and vice versa, especially with investors who are more focused on rates and less on duration.