The segmented markets theory states that the market for bonds is ‘segmented’ on the basis of the bonds’ term structure, and that ‘segmented’ markets operate more or less independently. Under the segmented markets theory, the return offered by a bond with a specific term structure is determined solely by the supply and demand for that bond and independent of the return offered by bonds with different term structures.
History of the Segmented Markets Theory
The Segmented Markets Theory was introduced by American economist John Mathew Culbertson (1921-2001) in his 1957 paper titled “The Term Structure of Interest Rates.” In his paper, Culbertson argued against Irving Fisher’s expectations driven model of the term structure and developed his own theory of how fixed income securities are priced by the market.
What is Term Structure?
Term structure, also known as the yield curve when graphically represented, is the relationship between the interest rate paid by an asset (usually government bonds) and the time to maturity. Interest rate is measured on the vertical axis and time to maturity is measured on the horizontal axis.
Normally, interest rates and time to maturity are positively correlated. Therefore, interest rates rise with an increase in the time to maturity. It results in the term structure taking on a positive slope. The yield curve is often seen as a bond market’s measure of confidence in the economy.
The segmented markets theory states that the bond market is full of heterogeneous agents with different income needs. Therefore, different agents in the bond market invest in different parts of the term structure based on their income needs.
Banks tend to mainly participate in the buying and selling of short-term bonds (it is mainly due to the modern banking practice of fractional reserves) whereas pension funds tend to mainly participate in the buying and selling of long-term bonds (it is mainly due to the stable income requirements of pension funds).
According to the expectations hypothesis, the return on any long-term fixed income security must be equal to the expected return from a sequence of short-term fixed income securities. Therefore, any long-term fixed income security can be recreated using a sequence of short-term fixed income securities.
However, the segmented markets theory also says that long-term fixed income securities and short-term fixed income securities are fundamentally different and should not be put in the same class of assets. In general, the holders of long-term bonds need to worry about a lot more things than the holders of short-term bonds.
For example, the holders of 10-year US government bonds need to worry about inflation for the next 10 periods and interest rates for the next 10 periods whereas the holders of 1-year US government bonds only need to worry about inflation for the next period and interest rate for the next period.
Therefore, the 10-year US government bond is a very different fixed income instrument from the 1-year US government bond, and a 10-year US government bond can’t be recreated using a sequence of ten 1-year US government bonds.
CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful: