Market Segmentation Theory

1. Market Segmentation Theory FNCE 4070Financial Markets and Institutions

2. Market Segmentation Theory • This theory states that the market for different-maturity bonds is completely separate and segmented. • The interest rate for a bond with a given maturity is determined by the supply and demand for bonds in that segment with no effect from the returns on bonds in other segments.

3. MST • We will consider the following market structure: • Two sectors – government bonds and corporate bonds • Two maturities – short-term and long-term

4. MST Demand • Most important factors determining demand for short-term (long-term) bonds are: • The interest rate on the bonds • Government policy • Wealth • Liquidity • Risk • The demand for short-term (long-term) bonds in one sector is inversely related to the demand in another sector (corporates vs government) but is not related to demand for the long-term (short-term) bonds in either sector

5. MST Supply • The supply for short-term and long-term corporate bonds are related to their • Price/interest rate • General economic conditions • Increasing in economic expansions • Decreasing in recessions • The supply of Treasury Bonds depends only on government actions (monetary and fiscal policy) • The supply of Treasury Bonds does not depend on the economic state or interest rates • The sale or purchase of treasury securities by the central bank or the treasury is a policy decision • This implies that the supply curve for Treasury bonds is vertical.

6. Market Segmentation Theory

7. Case 1: Economic Recession • Suppose the economy moves from a period of economic growth into a recession • Business demand for short-term and long-term assets teds to decrease. • Thus business supply for short-term and long-term bonds tends to decrease. • Creates excess demand for corporate bonds • Drives bond prices up and interest rates down. • Increased demand for corporate bonds increases demand for treasury bonds at existing yields • Drives treasury bond prices up and government interest rates down.

8. Case 2: Treasury Financing • Interest rates on Treasuries depends, in part, on the size and growth of the federal government debt. • If deficits are increasing over time then the Treasury will be constantly trying to raise funds in the markets • The choice of securities affects the yield curve for treasury bonds and by substitution the yield curve for corporates.

9. Case 2: continued • By choosing which securities to finance the deficit with the federal government can push short term rates upwards or long term rates upwards. • By substitution these actions will have a similar effect on the corporate yield curve

10. Case 3 : Open Market Operations • Expansionary OMO in which it buys short-term securities will cause the yield curve to become positively sloped • Expansionary OMO in which it buys long-term securities will cause the yield curve to become negatively sloped • Contractionary OMOs work in the opposite direction

11. Preferred Habitat Theory • Investors and borrowers have preferred maturity segments. • They may stray away from their desired maturity segments if there are relatively better rates to compensate them.