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

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  • XAVIER GABAIX
  • ARVIND KRISHNAMURTHY
  • OLIVIER VIGNERON

Abstract

“Limits of Arbitrage” theories hypothesize that the marginal investor in a particular asset market is a specialized arbitrageur rather than a diversified representative investor. We examine the mortgage‐backed securities (MBS) market in this light. We show that the risk of homeowner prepayment, which is a wash in the aggregate, is priced in the MBS market. The covariance of prepayment risk with aggregate wealth implies the wrong sign to match the observed prices of prepayment risk. The price of risk is better explained by a kernel based on MBS market‐wide specific risk, consistent with the specialized arbitrageur hypothesis.

Suggested Citation

  • Xavier Gabaix & Arvind Krishnamurthy & Olivier Vigneron, 2007. "Limits of Arbitrage: Theory and Evidence from the Mortgage‐Backed Securities Market," Journal of Finance, American Finance Association, vol. 62(2), pages 557-595, April.
    • Handle: RePEc:bla:jfinan:v:62:y:2007:i:2:p:557-595
    DOI: 10.1111/j.1540-6261.2007.01217.x
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    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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