Negative Arbitrage occurs when an institute borrows a sum of money at a higher rate and gets interest on that amount at a lower rate than the rate of borrowing. Basically, the borrowing cost is more than the lending cost.
For example, lets say that ABC City wants to build new bridges within the city limits. It issues Rs. 100,000,000 at 6% municipal bonds for the construction costs of these new bridges. The bond sale goes successful, but while the issue is going on, interest rates fall in the market.
Once the offering is completed and ABC City obtains the Rs. 100,000,000 amount, the municipality puts the money through bond proceeds in bank accounts. These will be used to pay for the construction expenditure as and when there is a need of payments to be made. However, due to the fall in interest rates, ABC City ends up earning only 3% in the bank account where the proceeds have been parked. Paying bondholders 5% is a necessity and this will result in a loss to the city. Thus, ABC City loses 3% due to the effect of negative arbitrage on the bond borrowing.
Negative Arbitrage is important as it basically is a form of opportunity cost. As shown in the example above, the city municipality has to bear a loss. This results in less money available for actual construction o the bridges. The Federal Reserve uses this method to ensure that short term rates decrease to result I increase in the opportunity cost. This acts as a kind of stimulus for the overall economy.
The loss in opportunity is because the money is reinvested at a rate lower than the rate at which the payments have to be made to the bond holders.
Hence, this concludes the definition of Negative Arbitrage along with its overview.
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