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


Xavier Gabaix


New York University - Stern School of Business; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI)

Arvind Krishnamurthy


Northwestern University - Kellogg School of Management

Olivier Vigneron


UBM

February 16, 2005

EFA 2004 Maastricht Meetings Paper No. 4940
Fifteenth Annual Utah Winter Finance Conference

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. A pricing kernel based on aggregate consumption or aggregate wealth implies the wrong sign for the price of MBS risk. The evidence suggests that limits of arbitrage theories can explain the cross-sectional and time-series behavior of spreads in this market.

Number of Pages in PDF File: 44

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

JEL Classification: G12, G12, G14, G21

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Date posted: June 11, 2004  

Suggested Citation

Gabaix, Xavier and Krishnamurthy, Arvind and Vigneron, Olivier, Limits of Arbitrage: Theory and Evidence from the Mortgage-Backed Securities Market (February 16, 2005). EFA 2004 Maastricht Meetings Paper No. 4940; Fifteenth Annual Utah Winter Finance Conference. Available at SSRN: http://ssrn.com/abstract=556116 or http://dx.doi.org/10.2139/ssrn.556116

Contact Information

Xavier Gabaix (Contact Author)
New York University - Stern School of Business ( email )
Stern School of Business
44 West 4th Street, Suite 9-190
New York, NY 10012-1126
United States
HOME PAGE: http://pages.stern.nyu.edu/~xgabaix/
National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
Centre for Economic Policy Research (CEPR)
77 Bastwick Street
London, EC1V 3PZ
United Kingdom
European Corporate Governance Institute (ECGI)
c/o ECARES ULB CP 114
B-1050 Brussels
Belgium
Arvind Krishnamurthy
Northwestern University - Kellogg School of Management ( email )
2001 Sheridan Road
Evanston, IL 60208
United States
847-491-2671 (Phone)
847-491-5719 (Fax)
Olivier Vigneron
UBM ( email )
95 Queen Victoria Street
London EC4V 4HN
United Kingdom
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