44 Pages Posted: 11 Jun 2004
Date Written: February 16, 2005
"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.
Keywords: Market segmentation, prepayment risk, liquidity, limited capital, hedge funds, limits to arbitrage.
JEL Classification: G12, G12, G14, G21
Suggested Citation: 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: https://ssrn.com/abstract=556116 or http://dx.doi.org/10.2139/ssrn.556116