7.7.4Market segmentation

Consider the relationship we have so far proposed between short-term and long-

term interest rates. Take our comparison between interest rates on one-year and on

ve-year bonds. Assume the current one-year bond rate is 8 per cent while 10.5 per

cent is payable on a ve-year bond indicating:

l	that short-term rates are expected to rise in the future;
l	that borrowers prefer to borrow long; and

l	that lenders require a term premium to persuade them to lend long (that is, they are capital risk averse).

Suppose next that the current one-year rate unexpectedly falls to 7.5 per cent.

Five-year bonds at 10.5 per cent will now seem more attractive than before and

people will switch towards them, pushing up their price and forcing interest rates

on them below 10.5 per cent. The position of the yield curve will change, but there

will be no change in its shape. It is often assumed that this will happen very quickly

– that is, that short-term and long-term rates are closely linked. In effect, we are

assuming that there is a single market for funds and changes in one part of the

market are quickly communicated to other parts of it.

Is this necessarily the case? Imagine that people holding short-term bonds so

strongly wish to keep their funds in liquid form that the greater relative attractiveness

of long-term bonds does not inuence them. Perhaps they are strongly capital risk-

averse. Alternatively, they may, as with banks and building societies, need to keep a

proportion of their assets in very liquid form in order to be able to meet unexpected

calls upon them. Again, they may wish to have funds available in case they want to

switch from nancial assets into goods (increase purchase of consumer durables) or

to meet unexpected debts. Further, the transaction costs involved in switching from

one type of asset to another may be very high or people may be poorly informed

about the different types of asset available and the interest rates payable on them.

The market for funds, we are saying, may be segmented. Some savers choose short-term

securities, others choose long-term ones, irrespective of the difference in interest rates

between them. Long-term bonds are not substitutes for short-term ones. Instead of

thinking of a continuous yield curve showing the relationship between interest

rates on assets of different maturities, we could think of a series of separate markets

for assets of different maturities, with the interest rates payable on each type of asset

being determined simply by demand and supply for that asset. There would be no

link between the different interest rates.

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