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Archive / Investment Adviser (Level 1) / Investing in Fixed Income Securities
nism-series-xa-segmented-markets-theory-bond-yields[ INVESTMENT ADVISER (LEVEL 1) ]

According to the 'Segmented Markets Theory' of the yield curve, what determines the yields for different bond maturities?

[ A ]A single formula dictated by the mathematical average of expected future overnight call rates.
[ B ]Uniform liquidity risk premiums that increase identically across all financial markets.
[ C ]Independent supply and demand dynamics within distinct maturity segments, driven by institutional participants who are constrained by statutory mandates or liability matching.[ CORRECT ]
[ D ]The ratio of physical gold reserves held by commercial banks relative to their deposits.
Takeaway

Segmented Markets Theory holds that bond yields across different maturities are set by independent supply and demand within each maturity segment, driven by institutional investors constrained to specific tenors by statutory mandates or liability-matching needs.

Derivation
Unlike Pure Expectations Theory (which assumes investors freely substitute across maturities based on rate expectations) or Liquidity Preference Theory (which assumes a smooth liquidity premium across the curve), Segmented Markets Theory argues that structural constraints — banks preferring short-tenor assets to match short-tenor deposits, pension funds and insurers needing 20-30 year assets to match long-dated liabilities — mean investors in each maturity bucket largely don't compete with investors in other buckets. As a result, yields in each segment are set locally by that segment's own supply-demand balance, which can produce yield-curve shapes (including humps or inversions) that the smoother expectations-based theories cannot fully explain.
Why the others fail
A — A single formula dictated by the mathematical average of expected future overnight call rates.
A single average-of-expected-future-rates formula describes Pure Expectations Theory's mechanism, the opposite premise of Segmented Markets Theory.
B — Uniform liquidity risk premiums that increase identically across all financial markets.
Uniform liquidity premiums increasing identically across all markets is the mechanism proposed by Liquidity Preference Theory, not Segmented Markets Theory.
D — The ratio of physical gold reserves held by commercial banks relative to their deposits.
Gold reserve ratios held by commercial banks relate to reserve/monetary policy metrics, entirely unconnected to the maturity-segment supply-demand mechanics that Segmented Markets Theory describes.