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IAI Actuarial Core Principles · Economic Modelling · Models of the term structure of interest rates

Which statement best describes the market segmentation theory of the term structure?

Market segmentation theory says yields at each maturity are determined by supply and demand within that maturity segment, because investors such as insurers or banks prefer particular terms and do not readily switch between them.

  1. ALong yields equal averages of expected future short rates
  2. BYields at each maturity are set by supply and demand from investors who prefer particular maturitiesCorrect
  3. CInvestors switch freely between maturities to exploit small yield differences
  4. DForward rates are always equal to current short rates
  5. The yield curve must be upward sloping because of liquidity premiums

Explanation

Market segmentation holds that investors, such as insurers matching long liabilities, stay within preferred maturity ranges, so each segment's yield is set by its own supply and demand. Free switching is the opposite of this assumption.

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