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FRM Part I · FRM Exam Part I · Interest Rates

A pension fund has long-dated liabilities and strongly prefers to hold long-maturity bonds, while banks prefer short-term assets. Yields in each maturity range are set mainly by supply and demand within that range. Which theory does this describe?

This describes the market segmentation theory. It assumes that investors and borrowers, such as pension funds and banks, stick to particular maturity ranges, so yields in each segment are determined by supply and demand there rather than by expected future short rates or a term premium.

  1. APure expectations theory
  2. BLiquidity preference theory
  3. CMarket segmentation theoryCorrect
  4. DArbitrage-free Vasicek theory

Explanation

Market segmentation holds that investors and borrowers have maturity-specific preferences, and rates in each segment are set by supply and demand in that segment. Pure expectations and liquidity preference both link maturities through expected rates.

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