Chartered Financial Analyst (CFA) Practice Exam Level 2

According to Segmented Market Theory, what do the short-term, medium-term, and long-term bond markets represent?

1. Different levels of risk

2. Different interest rates

3. Different or segmented markets

4. Same market with varied products

The correct answer is: Different or segmented markets

Segmented Market Theory posits that different segments of the bond market – such as short-term, medium-term, and long-term bonds – operate as distinct markets, each characterized by its own supply and demand dynamics. According to this theory, investors have specific preferences for certain maturities based on their investment goals, risk tolerance, and liquidity needs. As a result, each segment is influenced by its own factors, leading to unique sets of interest rates and risks associated with each maturity range. This separation means that changes in yields in one segment do not necessarily reflect changes in the other segments. Therefore, the correct interpretation of the short-term, medium-term, and long-term bond markets under Segmented Market Theory is that they represent different or segmented markets, as each serves different investor preferences and constraints. The other options present more generalized concepts such as different levels of risk or interest rates applicable across the entire market, which do not align with the theory's emphasis on the distinct separation between different maturity segments. Additionally, the notion of a single market with varied products fails to capture the fundamental idea of segmentation inherent in this theory.