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

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