In the context of municipal bonds, arbitrage relates to the investment of bond proceeds. In the case of positive arbitrage, which is restricted by federal law, a state or local government issues tax-exempt bonds at relatively low interest rates, then invests those bond proceeds in the higher-yielding taxable market.
Negative arbitrage is essentially the opposite: a state or local government issues bonds and the proceeds, when invested, earn less than the interest paid on the bonds. For example, the government may issue bonds paying 3 percent interest; due to market conditions, however, the government may earn only 2 percent off the invested proceeds.
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