THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 158

126

PA R T I I

Financial Markets
The expectations theory is an attractive theory because it provides a simple
explanation of the behaviour of the term structure, but unfortunately it has a major
shortcoming: it cannot explain fact 3, that yield curves usually slope upward. The
typical upward slope of yield curves implies that short-term interest rates are usually
expected to rise in the future. In practice, short-term interest rates are just as likely
to fall as they are to rise, and so the expectations theory suggests that the typical
yield curve should be flat rather than upward-sloping.

Segmented
Markets
Theory

As the name suggests, the segmented markets theory of the term structure sees
markets for different-maturity bonds as completely separate and segmented. The
interest rate for each bond with a different maturity is then determined by the supply of and demand for that bond with no effects from expected returns on other
bonds with other maturities.
The key assumption in the segmented markets theory is that bonds of
different maturities are not substitutes at all, so the expected return from holding a bond of one maturity has no effect on the demand for a bond of another
maturity. This theory of the term structure is at the opposite extreme to the
expectations theory, which assumes that bonds of different maturities are perfect substitutes.
The argument for why bonds of different maturities are not substitutes is that
investors have very strong preferences for bonds of one maturity but not for
another, so they will be concerned with the expected returns only for bonds of the
maturity they prefer. This might occur because they have a particular holding
period in mind, and if they match the maturity of the bond to the desired holding
period, they can obtain a certain return with no risk at all.3 (We have seen in

Chapter 4 that if the term to maturity equals the holding period, the return is
known for certain because it equals the yield exactly, and there is no interest-rate
risk.) For example, people who have a short holding period would prefer to hold
short-term bonds. Conversely, if you were putting funds away for your young
child to go to college, your desired holding period might be much longer, and you
would want to hold longer-term bonds.
In the segmented markets theory, differing yield curve patterns are accounted
for by supply and demand differences associated with bonds of different maturities. If, as seems sensible, investors have short desired holding periods and
generally prefer bonds with shorter maturities that have less interest-rate risk,
the segmented markets theory can explain fact 3, that yield curves typically
slope upward. Because in the typical situation the demand for long-term bonds
is relatively lower than that for short-term bonds, long-term bonds will have
lower prices and higher interest rates, and hence the yield curve will typically
slope upward.
Although the segmented markets theory can explain why yield curves usually
tend to slope upward, it has a major flaw in that it cannot explain facts 1 and 2.
Because it views the market for bonds of different maturities as completely segmented, there is no reason for a rise in interest rates on a bond of one maturity to

3

The statement that there is no uncertainty about the return if the term to maturity equals the holding
period is literally true only for a discount bond. For a coupon bond with a long holding period, there
is some risk because coupon payments must be reinvested before the bond matures. Our analysis here
is thus being conducted for discount bonds. However, the gist of the analysis remains the same for
coupon bonds because the amount of this risk from reinvestment is small when coupon bonds have
the same term to maturity as the holding period.