Suppose that interest rates on Treasury Bills and Treasury Bonds as reported for

Question

Suppose that interest rates on Treasury Bills and Treasury Bonds as reported for July 12, 1990 are as follows:

       Term     Rate (%)
       3 Month     7.79
       6 Month    7.75
       1 Year     7.62
       5 Year     7.50

(a)    Provide definitions of the market segmentation and preferred habitat hypotheses and explanations for the above yield curve based upon these two hypotheses.

(b)    Provide an explanation in words how the yield to maturity for a newly issued 90 day bond and the 5 year bond were determined.

(c)   Suppose that the interest rate reported above for the 5 year bond represented a decrease from the interest rate on the same bond in the previous year. Explain what happened to the bond price and the rate of return as a result. Explain why, based upon the characteristics of the bond in determining the interest rate as a yield to maturity.

Explanation / Answer

Market segmentation is a marketing strategy which involves dividing a broad targetmarket into subsets of consumers, businesses, or countries that have, or are perceived to have, common needs, interests, and priorities, and then designing and implementing strategies to target them.

A term structure theory suggesting that different bond investors prefer one maturity length over another and are only willing to buy bonds outside of their maturity preference if a risk premium for the maturity range is available. The theory also suggests that when all else is equal investors prefer to hold short-term bonds in place of long-term bonds and that the yields on longerterm bonds should be higher than shorter term bonds.

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