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Journal of Finance Vol. 62 No. 2 2007

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

Xavier Gabaix1; Arvind Krishnamurthy1; OLIVIER VIGNERON2

1 Center for Economic and Policy Research · 2 Authors, respectively, are at MIT and NBER, Northwestern University, and BNP Paribas. We thank Kobi Boudoukh, Donald Bronstein, John Campbell, Kent Daniel, Thomas Davidoff, John Geanakoplos, Massoud Heidari, Jingzhi Huang, Ravi Jagannathan, Adam Kolasinski, Ananth Krishnamurthy, Yong Liu, Francis Lo

open access

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, consistent with the specialized arbitrageur hypothesis.

DOI
10.1111/j.1540-6261.2007.01217.x
Volume
62
Issue
2
Pages
557-595
Language
en
Sources
openalex bibtex:phds-export.bib crossref

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