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IAI Actuarial Core Principles · Actuarial Mathematics for Modelling · Term structure of interest rates

According to the market segmentation theory, the shape of the yield curve is determined mainly by:

Under market segmentation, yields at each maturity are set by supply and demand within that maturity sector, because investors like insurers and pension funds prefer particular maturities to match their liabilities. The curve's shape thus reflects separate markets rather than expected future short rates.

  1. AExpected future short-term interest rates only
  2. BA constant liquidity premium added to every maturity
  3. CSupply and demand within separate maturity sectors, driven by investors with specific maturity preferencesCorrect
  4. DArbitrage between bonds of different maturities by risk-neutral investors
  5. The inflation rate in the current year only

Explanation

Market segmentation holds that investors such as pension funds and insurers match liabilities to particular maturities, so each sector has its own supply and demand and yield. Expectations and arbitrage across maturities are not central.

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