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The hypothesis that long-term interest rates contain a prediction of future short-term interest rates. Expectations theory postulates that you
would earn the same amount of interest by investing in a one-year bond today and rolling that investment into a new one-year bond a year
later compared to buying a two-year bond today.
Market segmentation theory posits that the behavior of short-term and long-term interest rates are mutually exclusive.
How it works/Example:
Market segmentation theory suggests that the behavior of short-term interest rates is wholly unrelated to the behavior of long-term interest rates. In
other words, a change in one is in no way indicative of an immediate change in the other. Both must be analyzed independently. Accordingly, the yield
curvereflects the market supply and demand for Treasury bonds of a certain maturity only.
Why it Matters:
Market segmentation theory suggests that it is impossible to predict future interest rate outcomes based on short-term interest rates. Moreover, longterm interest rates (for example, the rate of the 30-year Treasury bond) only express market expectations and do not indicate that a definite
outcome willoccur.
According to market segmentation theory, investors and borrowers do not consider their
short-term investments or borrowings as substitutes for long-term ones. This lack of
substitutability keeps interest rates of differing maturities independent of one another. If
investors or borrowers considered alternative maturities as substitutes, they may switch
between maturities. However, if investors and borrowers switch between maturities in
response to interest rate changes, interest rates for different maturities would no longer be
independent of each other. An interest rate change for one maturity would affect demand
andsupply, and hence interest rates, for other maturities.