Market Segmentation Theory – This theory reflects the impact of events in different segments of financial markets on the relationship between interest rates and loan maturities.
The theory posits that the market is divided into various segments, each with different preferences regarding bond maturities. For example, pension funds are more focused on long-term bonds, while banks are more interested in short-term bonds due to the nature of their deposits.
The theory asserts that no segment will change its maturity preferences unless adequately compensated for doing so.
The graphs below illustrate what happens when the supply of short-term loans decreases in favor of long-term loans. Horizontally, the top three graphs describe the initial state, while the bottom three depict the state after the change.
The relationship between interest rates and maturities changes (the slope of the curve). Interest rates become more elastic with respect to maturities.
Source: Financial Markets and Institutions – by A. Saunders, M. Cornett & O. Erhemjamts
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