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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.

Suggested Citation

  • Olivier Vigneron, & Xavier Gabaix & Arvind Krishnamurthy, 2004. "Limits of Arbitrage: Theory and Evidence from the Mortgage-Backed Securities Market," Econometric Society 2004 North American Summer Meetings 430, Econometric Society.
    • Handle: RePEc:ecm:nasm04:430
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    More about this item

    Keywords

    Market segmentation; prepayment risk; liquidity; limited capital; hedge funds; limits to arbitrage;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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