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

44 Pages Posted: 11 Jun 2004

See all articles by Xavier Gabaix

Xavier Gabaix

Harvard University - Department of Economics; 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

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)

Harvard University - Department of Economics ( email )

Littauer Center
Cambridge, MA 02138
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Centre for Economic Policy Research (CEPR)

London
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

Register to save articles to
your library

Register

Paper statistics

Downloads
897
Abstract Views
3,640
rank
23,553
PlumX Metrics