Question

Market segmentation theory explains the typical upward sloping shape of yield curves as a function of?

1) normally greater demand for long-term bonds than for short-term notes
2) normally greater demand for short term notes than for long-term bonds
3) expectations that inflation will be higher in the future than it is now
4) the greater liquidity of short-term notes as compared to long-term bonds

Answer 1

The Market Segmentation Theory explains the upward sloping yield curve by suggesting markets for different maturity bonds are separate and subject to their own supply and demand dynamics.

Step-by-step explanation:

The Market Segmentation Theory is an approach used to explain the structure of interest rates and the shape of the yield curve in financial markets. Specifically, it suggests that the yield curve takes its typical upward sloping shape due to segmented market operations where investors have distinct investment horizons and preferences that match the maturity of their preferred bonds. In this context, neither normally greater demand for long-term bonds than for short-term notes nor the greater liquidity of short-term notes necessarily explains the upward sloping curve, but rather the theory posits that markets for different maturity bonds are largely separate and thus each segment's supply and demand dynamics determine the prevailing interest rates in that segment.