Municipal Bond Arbitrage

DEFINITION of 'Municipal Bond Arbitrage'

A strategy that consists of building a portfolio of tax-exempt municipal bonds and simultaneously hedging the duration risk of the portfolio through the short sale of equivalent taxable corporate bonds of the same maturity, generally interest rate swaps. Because interest on municipal bonds is exempt from federal income tax, an arbitrageur can receive after-tax income from the municipal bond portfolio that is higher than the interest paid on the interest rate swap.

BREAKING DOWN 'Municipal Bond Arbitrage'

The implicit assumption in this arbitrage is that the municipal bonds and interest rate swaps will continue to have a close correlation. The strategy seeks to minimize credit risk and duration risk by using municipal bonds and interest rate swaps of similar quality and maturity.

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RELATED FAQS
  1. What is arbitrage?

    Arbitrage is basically buying in one market and simultaneously selling in another, profiting from a temporary difference. ... Read Full Answer >>
  2. What is a derivative?

    A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, ... Read Full Answer >>
  3. Do mutual funds invest only in stocks?

    Mutual funds invest in stocks, but certain types also invest in government and corporate bonds. Stocks are subject to the ... Read Full Answer >>
  4. What is the relationship between the current yield and risk?

    The general relationship between current yield and risk is that they increase in correlation to one another. A higher current ... Read Full Answer >>
  5. Is there a difference between financial spread betting and arbitrage? (AAPL, NFLX)

    Financial spread betting is a type of speculation that involves a highly leveraged derivative product, whereas arbitrage ... Read Full Answer >>
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