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





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    • 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 Longstaff, Bob McDonald, Andrew Metrick, Anna Pavlova, Matt Richardson, Tim Riddiough, Anthony Sanders, José Scheinkman, Richard Stanton, René Stulz, Raman Uppal, Dimitri Vayanos, Nancy Wallace, and Bill Wheaton for valuable comments. We are particularly grateful to the referee for many constructive suggestions. We thank participants at the NBER Asset Pricing meeting, Econometric Society Summer meeting, Gerzensee-CEPR meeting, WFA, Utah Finance Conference, and at seminars at UC-Berkeley, University of British Columbia, University of Chicago, HEC-Montreal, LBS, LSE-FMG, MIT, University of Maryland, NYU, and Northwestern for their comments. We also thank Salomon Smith Barney, Smith-Breeden, and UBS for providing data. Kripa Freitas provided excellent research assistance. All errors are our own.


“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.