Definition
Segmented Market Theory is a concept in finance suggesting that the interest rates for comparable assets differ due to differences in the characteristics of the markets or investing groups. This implies that financial markets are “segmented”, meaning that they are separate and not influenced by other markets. Therefore, according to this theory, it is primarily the supply and demand conditions within each market segment that determine the prices and rates of return for a particular class of securities.
Key Takeaways
- Segmented Market Theory suggests that the market for different types of securities is completely segmented and separate. This implies that the interest rates for different types of securities are determined primarily by the supply and demand conditions within each segment.
- This theory highlights the limitations of capital mobility between different market segments. Factors such as regulation, investor preference, transaction costs, and financial reporting requirements can prevent investors from moving freely from one segment to another.
- Considered as a critique of the expectations theory, the Segmented Market Theory disagrees with the notion that the yields of different maturity bonds are determined solely by future short-term interest rate expectations. It emphasizes investor preferences for specific maturities based on their investment time horizons and risk profiles.
Importance
The Segmented Market Theory is important in finance as it explains the characteristics and fluctuations in interest rates of different types of bonds.
According to this theory, investors have specific preferences and constraints which bind them to certain segments of the bond market, thereby creating markets that operate independently of each other.
This segmentation can influence the supply and demand for different kinds of bonds, which in turn impacts their prices and yields.
The theory aids in understanding why different bonds with similar characteristics may carry different interest rates, and it provides insights into how economic events can affect various segments of the bond market uniquely.
Understanding this can help investors to strategize their investments and manage risks better.
Explanation
The Segmented Market Theory serves a crucial purpose in understanding the operation of markets, especially those related to financial securities such as bonds. Essentially, this theory helps explain why different investors prefer different kinds of bonds (long-term vs short-term), based on their specific investment perspectives and needs.
It provides the rationale for the existence and functioning of different segments in a broader market, why these segments might work independently of each other, and how segmentation can impact price and returns. Moreover, the Segmented Market Theory is used to analyze interest rate behavior.
In simpler terms, it explains why interest rates for different types of bonds do not necessarily move together. According to the theory, interest rates for a particular segment are determined by the supply and demand forces within that specific segment and not the entire bond market.
As each segment is insulated from others, a change in demand in one doesn’t directly affect the rest. Hence, it’s essential in examining supply and demand functions in isolated segments and understanding the variations in yields across different bond maturities.
Examples of Segmented Market Theory
Foreign Exchange Markets: The segmented market theory often separates domestic investors from foreign investors. A typical example can be found in the foreign exchange markets. In countries where strict capital control policies are adopted, foreign investors are often barred from investing in domestic assets. Therefore, domestic and foreign investors operate in two segmented markets, which can lead to a large disparity in foreign exchange rates.
Real Estate Markets: Different regions or cities have their own unique factors that affect property values, such as employment availability, economic growth, infrastructure, or local laws and regulations. For this reason, real estate markets in different areas can be heavily segmented. For example, property prices in New York may be influenced by different factors than property prices in a rural area in Midwest USA, creating a separation or segmentation in the market.
Stock Markets: Different stock markets can be categorized as segmented due to the access of investors. An example is emerging markets versus developed ones. Investors, particularly international ones, may have much easier access to stocks in developed countries compared to emerging markets due to various reasons such as less stringent regulations, better transparency, among others. Thus these two segments (emerging and developed markets) can behave distinctly based on the set of investors that operate in them.
FAQs – Segmented Market Theory
What is Segmented Market Theory?
Segmented Market Theory is a concept in financial economics that explains the differences in individual preferences and institutional constraints influencing the behavior of security prices.
Who developed the Segmented Market Theory?
The Segmented Market Theory was principally developed by economists who were trying to explain the anomalies in security prices through individual preferences and institutional constraints.
What are the basic assumptions of the Segmented Market Theory?
The primary assumption of the Segmented Market Theory is that markets are “segmented”. This implies that different groups of investors have preferences for different kinds of securities and this segmentation affects the price and yield of these securities.
How does Segmented Market Theory impact pricing?
The Segmented Market Theory states that prices of securities are greatly influenced by the demand and supply of various groups of investors. If a particular group of investors prefers a certain kind of security, the prices of that security may increase due to the heightened demand.
Where does the Segmented Market Theory find application?
Segmented Market Theory is widely used in predicting and explaining anomalies in securities prices. It has profound implications in portfolio management, investment analysis, and financial decision making.
Related Entrepreneurship Terms
- Interest Rate Risk
- Market Segmentation
- Liquidity Preference Theory
- Yield Curve
- Maturity
Sources for More Information
- Investopedia: A comprehensive resource for anything investment and finance related. They offer a user-friendly layout with a wide range of articles on various theories including the Segmented Market Theory.
- Corporate Finance Institute: They offer a collection of knowledge on financial topics, course programs, templates, and guides that can give you a deep understanding about Segmented Market Theory.
- The Balance: Provides expertly crafted financial advice and information including a wide array of financial topics like the Segmented Market Theory.
- Khan Academy: A platform offering subjects across different disciplines, including finance. They often provide content about financial theories, including Segmented Market Theory.
