NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

NBER Publications by Olivier Vigneron

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Working Papers and Chapters

December 2005Limits of Arbitrage: Theory and Evidence from the Mortgage-Backed Securities Market
with Xavier Gabaix, Arvind Krishnamurthy: w11851
"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.

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