Negative Arbitrage

Written By
Paul Tracy
Updated November 4, 2020

What is Negative Arbitrage?

Negative arbitrage occurs when the interest rate a borrower pays on its debt is higher than the interest rate the borrower earns on the money that will be used to repay the debt.

How Does Negative Arbitrage Work?

For example, let's assume that XYZ City wants to build several new bridges. It issues $100,000,000 of 5% municipal bonds in order to pay for the construction costs. The bond sale is successful, but while the offering is in process, interest rates fall across the board.

Once the offering is done and XYZ City obtains the $100,000,000, the city puts the bond proceeds in several bank accounts that it will use to pay for the construction as the costs are incurred. However, due to the changes in interest rates, XYZ City ends up earning only 2% in the bank accounts while paying bondholders 5%. Thus, XYZ City loses 3% due to negative arbitrage.

Bond issuers try to avoid negative arbitrage by creating draw-down funds, which allow borrowers to pay interest only on the portion of the proceeds that has been used. Draw-down funds are sometimes part of private placements. Investing proceeds more aggressively is another (albeit riskier) option.

Why Does Negative Arbitrage Matter?

Negative arbitrage is an opportunity cost. In our example, changes in interest rates forced XYZ City to invest at a lower rate than it pays out. In turn, less money is available for the actual construction costs. This is one example of how Federal Reserve efforts to stimulate the economy by lowering short term interest rates can actually increase opportunity costs and inadvertently stymie infrastructure investment.

Activate your free account to unlock our most valuable savings and money-making tips
  • 100% FREE
  • Exclusive money-making tips before we post them to the live site
  • Weekly insights and analysis from our financial experts
  • Free Report - 25 Ways to Save Hundreds on Your Monthly Expenses
  • Free Report - Eliminate Credit Card Debt with these 10 Simple Tricks
Ask an Expert
All of our content is verified for accuracy by Paul Tracy and our team of certified financial experts. We pride ourselves on quality, research, and transparency, and we value your feedback. Below you'll find answers to some of the most common reader questions about Negative Arbitrage.
Be the first to ask a question

If you have a question about Negative Arbitrage, then please ask Paul.

Ask a question

Paul has been a respected figure in the financial markets for more than two decades. Prior to starting InvestingAnswers, Paul founded and managed one of the most influential investment research firms in America, with more than 3 million monthly readers.

If you have a question about Negative Arbitrage, then please ask Paul.

Ask a question Read more from Paul
Paul Tracy - profile
Ask an Expert about Negative Arbitrage

By submitting this form you agree with our Privacy Policy

Don't Know a Financial Term?
Search our library of 4,000+ terms