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Limits of Arbitrage: Theory and Evidence from the Mortgage-Backed Securities Market

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  • Olivier Vigneron,
  • Xavier Gabaix
  • Arvind Krishnamurthy

Abstract

``Limits of Arbitrage" theories require that the marginal investor in a particular asset market be a specialized arbitrageur. Then the constraints faced by this arbitrageur (i.e. capital constraints) feed through into asset prices. We examine the mortgage-backed securities (MBS) market in this light, as casual empiricism suggests that investors in the MBS market do seem to be very specialized. We show that risks that seem relatively minor for aggregate wealth are priced in the MBS market. A simple pricing kernel based on the aggregate value of MBS securities prices risk in the MBS market. The evidence suggests that limits of arbitrage theories can help explain the behavior of spreads in this market.

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Paper provided by Econometric Society in its series Econometric Society 2004 North American Summer Meetings with number 430.

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Date of creation: 11 Aug 2004
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Handle: RePEc:ecm:nasm04:430

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Keywords: Market segmentation; prepayment risk; liquidity; limited capital; hedge funds; limits to arbitrage;

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