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

  • Xavier Gabaix
  • Arvind Krishnamurthy
  • Olivier Vigneron

"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. This finding is consistent with the specialized arbitrageur hypothesis.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 11851.

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Date of creation: Dec 2005
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Publication status: published as 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, 04.
Handle: RePEc:nbr:nberwo:11851
Note: AP
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