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

44 Pages Posted: 11 Jun 2004  

Xavier Gabaix

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

Arvind Krishnamurthy

Northwestern University - Kellogg School of Management

Olivier Vigneron

UBM

Multiple version iconThere are 2 versions of this paper

Date Written: February 16, 2005

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.

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

JEL Classification: G12, G12, G14, G21

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

Xavier Gabaix (Contact Author)

New York University - Stern School of Business ( email )

Stern School of Business
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HOME PAGE: http://pages.stern.nyu.edu/~xgabaix/

Harvard University - Department of Economics ( email )

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National Bureau of Economic Research (NBER)

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Centre for Economic Policy Research (CEPR)

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European Corporate Governance Institute (ECGI)

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Arvind Krishnamurthy

Northwestern University - Kellogg School of Management ( email )

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United States
847-491-2671 (Phone)
847-491-5719 (Fax)

Olivier Vigneron

UBM ( email )

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London EC4V 4HN
United Kingdom

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