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

Gabaix, Xavier; Krishnamurthy, Arvind; Vigneron, Olivier

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

NBER Working Paper No. w11851

47 Pages Posted: 8 Mar 2006 Last revised: 20 Nov 2022

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

There are 2 versions of this paper

Date Written: December 2005

Abstract

"Limits of Arbitrage" theories hypothesize that the marginal investor in a particular asset market is a specialized arbitrageur rather than a diversified representative investor. We examine the mortgage-backed securities (MBS) market in this light. We show that the risk of homeowner prepayment, which is a wash in the aggregate, is priced in the MBS market. The covariance of prepayment risk with aggregate wealth implies the wrong sign to match the observed prices of prepayment risk. The price of risk is better explained by a kernel based on MBS-market-wide specific risk. This finding is consistent with the specialized arbitrageur hypothesis.

Suggested Citation: Suggested Citation

Gabaix, Xavier and Krishnamurthy, Arvind and Vigneron, Olivier, Limits of Arbitrage: Theory and Evidence from the Mortgage-Backed Securities Market (December 2005). NBER Working Paper No. w11851, Available at SSRN: https://ssrn.com/abstract=875709