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

Xavier Gabaix · Arvind Krishnamurthy · Olivier Vigneron

295 citations0/0 files storedThe Journal of Finance

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Financial Markets and Investment Strategies Housing Market and Economics Credit Risk and Financial Regulations

Abstract

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.

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1974ON THE PRICING OF CORPORATE DEBT: THE RISK STRUCTURE OF INTEREST RATES*1987A Simple Model of Capital Market Equilibrium with Incomplete Information 1995The Limits of Arbitrage 1997Financial Intermediation, Loanable Funds, and The Real Sector 1987Aggregation and Linearity in the Provision of Intertemporal Incentives 2018The Economy as an Evolving Complex System II 2001The Determinants of Credit Spread Changes 2003A theory of power-law distributions in financial market fluctuations

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