Working Paper: NBER ID: w11851
Authors: Xavier Gabaix; Arvind Krishnamurthy; Olivier Vigneron
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. This finding is consistent with the specialized arbitrageur hypothesis.
Keywords: Mortgage-Backed Securities; Limits of Arbitrage; Prepayment Risk
JEL Codes: G12; G14; G21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| prepayment risk (G21) | positive risk premium (G19) |
| covariance of prepayment risk with aggregate wealth or consumption (E21) | sign opposite to traditional asset pricing theory (G19) |
| marginal investor in MBS market (G21) | not a representative investor (G19) |
| pricing of prepayment risk (G19) | influenced by specialized investors (G24) |
| market price of prepayment risk comoves with riskiness proxy (G17) | market conditions affect pricing of prepayment risk (G19) |