This theory states that the major investors (borrowers and lenders) are confined to a particular segment of the market and will not change even if the forecast of the likely future interest rates changes.
The lenders and borrower thus have a preferred maturity e.g a person borrowing to buy a house or a company borrowing to build a power plant would want a long term loan. However a retailer borrowing to build up stock in readiness for a peak reason would prefer a short term loan. Similar differences exist among savers e.g a person saving to pay school fees for next semester would want to lend on in the short-term market. A person saving for retirement 20 years ahead would probably buy long-term security in L.T market.
The thrust of market segmentation theory is that the slope of yield curve depends on demand and supply mechanism. An upward sloping curve would occur if there was a large supply of funds relative to demand in the short term marketing but a relative shortage of funds in the long-term market would produce an upward sloping curve.