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

Xavier Gabaix, Arvind Krishnamurthy and Olivier Vigneron

No 11851, NBER Working Papers from National Bureau of Economic Research, Inc

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. This finding is consistent with the specialized arbitrageur hypothesis.

JEL-codes: G12 G14 G21 (search for similar items in EconPapers)
Date: 2005-12
New Economics Papers: this item is included in nep-fin, nep-fmk and nep-ure
Note: AP
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Citations: View citations in EconPapers (2)

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.

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Related works:
Journal Article: Limits of Arbitrage: Theory and Evidence from the Mortgage‐Backed Securities Market (2007)
Working Paper: Limits of Arbitrage: Theory and Evidence from the Mortgage-Backed Securities Market (2004)
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