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

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In this Subject: Finance
By this author: GABAIX, XAVIER ;&nbsp; KRISHNAMURTHY, ARVIND ;&nbsp; VIGNERON, OLIVIER

Authors: GABAIX, XAVIER; KRISHNAMURTHY, ARVIND; VIGNERON, OLIVIER

Source: The Journal of Finance, Volume 62, Number 2, April 2007 , pp. 557-595(39)

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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.

Document Type: Research article

DOI: http://dx.doi.org/10.1111/j.1540-6261.2007.01217.x

Publication date: 2007-04-01