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FRM Part I · FRM Exam Part I · Interest Rates

According to market segmentation theory, which statement about the yield curve is correct?

Market segmentation theory says yields at each maturity are determined by supply and demand within that maturity sector, because participants restrict themselves to particular maturities. It contrasts with pure expectations, where long rates are averages of expected short rates, and with theories allowing free substitution across maturities.

  1. ALong-term rates equal the geometric average of expected short-term rates
  2. BYields at each maturity are set by supply and demand within that maturity sectorCorrect
  3. CInvestors shift freely across maturities whenever expected returns differ
  4. DTerm premiums are always positive and rise with maturity

Explanation

Market segmentation holds that investors and borrowers have strict maturity preferences, so each sector's rate is set by its own supply and demand. The first option describes pure expectations, the third describes arbitrage-driven substitution, and the fourth describes liquidity preference.

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