how negative arbitrage works
negative arbitrage occurs when a borrower pays off its debts at a higher interest rate than the rate the borrower earns on the money set aside to repay the debt basically the borrowing cost is more than the lending cost for example to fund the construction of a highway a state government issues 50 million in municipal bonds paying 6 but while the offering is still in process prevailing interest rates in the market fall the proceeds from the bond issuance are subsequently invested in a money market account paying only 4 2 for a period of one year because the prevailing market will not pay a higher rate in this case the issuer loses the equivalent of 1 8 interest that it could have earned or retained the 1 8 results from negative arbitrage which is in fact an opportunity cost the loss incurred by the state translates into less available funds for the highway project for its citizens negative arbitrage and refunding bondsthe concept of negative arbitrage can be shown using the example of refunding bonds if interest rates decrease below the coupon rate on existing callable bonds an issuer is likely to pay off the bond and refinance its debt at the lower interest rate prevalent in the market the proceeds from the new issue the refunding bond will be used to settle the interest and principal payment obligations of the outstanding issue the refunded bond however due to the call protection placed on some bonds which prevents an issuer from redeeming the bonds for a period of time proceeds from the new issue are used to purchase treasury securities held in escrow on the call date after the call protection elapses the treasuries are sold and the proceeds from the sale are used to retire the older bonds 