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FRM Part I · FRM Exam Part I · Properties of Interest Rates

Pension funds heavily demand long-dated bonds to match long-term liabilities, while banks prefer short-term securities, so each maturity's yield is set by its own supply and demand. Which theory of the term structure does this describe?

This describes market segmentation theory, which says different investor groups stay in their preferred maturities, so yields at each maturity are set by separate supply and demand. Expectations-based theories link maturities through expected future short rates, which is not the mechanism described here.

  1. APure expectations theory
  2. BLiquidity preference theory
  3. CMarket segmentation theoryCorrect
  4. DPreferred habitat theory with free arbitrage across maturities

Explanation

Market segmentation theory holds that investors and borrowers stick to particular maturities, so yields at each maturity are determined by separate supply and demand. Pure expectations and liquidity preference relate yields to expected short rates, and the stated lack of cross-maturity movement rules out arbitrage across maturities.

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