Final answer:
The market segmentation theory states that the term structure of interest rates is determined by the behavior of different types of financial institutions. Investments are analyzed based on expected rate of return, risk, and liquidity. The correct option is B. market segmentation theory.
Step-by-step explanation:
The theory that suggests the term structure of interest rates is determined by the behavior of various types of financial institutions is the market segmentation theory. This theory essentially divides the financial institutions into segments based on the maturity of investments they prefer.
Our discussion has shifted to explain how households supply funds in financial markets, considering factors like expected rate of return, risk, and liquidity. Financial markets consist of diverse investment options, including bank accounts, bonds, stocks, and mutual funds, among others.
Each of these investments demands analysis on the three key factors, which in turn influence the choices and preferences of supplying funds to the markets by households and individual investors.
Bonds are one such investment class that offers a rate of return to the investor. Depending upon the riskiness of the borrower, bonds offer varying interest rates. Nonetheless, the interest rate can be decomposed into three parts, which include compensation for postponing consumption, adjustment for inflation, and a risk premium corresponding to the borrower's probability of default.