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Market segmentation theory ...Preferred Habitat Theory

Wallace finally asks the class about the market segmentation theory of the term structure of interest rates. Specifically, Wallace asks which of the following could explain an upward sloping yield curve according to the market segmentation theory?

A) There is greater demand for long-term securities than for short-term securities.

B) There is greater demand for short-term securities than for long-term securities.

C) There is a risk premium associated with more distant maturities.

Your answer: A was incorrect. The correct answer was B) There is greater demand for short-term securities than for long-term securities.

This could explain an upward sloping yield curve according to the market segmentation theory. The market segmentation theory implies that the rate of interest for a particular maturity is determined solely by demand and supply for that maturity, with no reference to conditions for other maturities.

A risk premium associated with more distant maturities could explain an upward sloping yield curve according to the liquidity preference theory. Greater demand for long-term securities than for short-term securities would drive the yields on long-term securities down and would result in an inverted (downward sloping) yield curve. (Study Session 14, LOS 55.e)

I always thought that the more demand the higher the yield would be.
So an upward slopping yield curve will be explain by higher demand in long-term securities than those of short term under Market Segmentation theory (Preferred Habitat Theory).

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Higher Demand>Higher Price>Lower Yield.