This situation can arise in various financial contexts, particularly in municipal finance and bond transactions, and can result in a financial loss if the gap between the two rates is significant.
Negative arbitrage is commonly seen in situations where the issuer borrows money at a higher interest rate than the returns generated by investing the proceeds.
For example, a municipality might issue bonds at a certain interest rate and invest the proceeds in short-term securities that offer a lower return.
If the interest rate on the borrowed funds is higher than the earnings from the investments, the difference represents negative arbitrage.
This scenario can lead to additional costs for the issuer, as they end up paying more on their borrowed funds than they earn from their investments.
For negative arbitrage, consider a municipality that issues bonds with a 4% interest rate.
The proceeds from the bond issuance are then invested in securities that yield only 2%. In this case, the municipality is paying 4% on the debt but only earning 2% on the investment, resulting in a 2% negative arbitrage. This means the municipality is losing money on the spread, which can be a financial burden if the discrepancy continues over time.
Negative arbitrage is generally undesirable because it represents a financial inefficiency.
However, it can sometimes occur intentionally in specific financing structures, such as in advance refunding transactions where bonds are issued to pay off old debt, and the funds are temporarily invested at lower returns until the call date.
Positive arbitrage occurs when the interest rate earned on invested funds is higher than the interest rate paid on borrowed funds. This situation is favorable to the borrower or issuer, as they can generate a profit by investing borrowed funds at a higher rate than what they pay in interest.
For example, if an issuer borrows at 3% and invests the funds at 5%, the difference of 2% represents positive arbitrage. This can create a surplus or profit for the issuer, especially in municipal finance, where funds may be borrowed at tax-exempt rates and invested in higher-yielding taxable securities.
Positive arbitrage can provide valuable financial benefits, especially in large-scale financing projects.
The key takeaway from understanding arbitrage, both negative and positive, is the importance of managing the spread between borrowing and investment rates.
Negative arbitrage increases financial costs and can hinder profitability or budget efficiency, especially for entities like municipalities or corporations involved in complex financing structures.
Positive arbitrage can be a beneficial strategy, allowing issuers to earn additional revenue from their borrowings.