Editing Arbitrage (section)

===Municipal bond arbitrage===
[[Municipal bond arbitrage]], also called ''municipal bond relative value arbitrage'', ''municipal arbitrage'', or just ''muni arb'', is a [[hedge fund]] strategy involving one of two approaches. The term "arbitrage" is also used in the context of the Income Tax Regulations governing the investment of proceeds of municipal bonds; these regulations, aimed at the issuers or beneficiaries of tax-exempt municipal bonds, are different and, instead, attempt to remove the issuer's ability to arbitrage between the low tax-exempt rate and a taxable investment rate.

Generally, managers seek relative value opportunities by being both long and short municipal bonds with a duration-neutral book. The relative value trades may be between different issuers, different bonds issued by the same entity, or capital structure trades referencing the same asset (in the case of revenue bonds). Managers aim to capture the inefficiencies arising from the heavy participation of non-economic investors (i.e., high income "[[buy and hold]]" investors seeking tax-exempt income) as well as the "crossover buying" arising from corporations' or individuals' changing income tax situations (i.e., insurers switching their munis for corporates after a large loss as they can capture a higher after-tax yield by offsetting the taxable corporate income with underwriting losses). There are additional inefficiencies arising from the highly fragmented nature of the municipal bond market which has two million outstanding issues and 50,000 issuers, in contrast to the Treasury market which has 400 issues and a single issuer.

Second, managers construct leveraged portfolios of AAA- or AA-rated tax-exempt municipal bonds with the duration risk hedged by [[Short selling|shorting]] the appropriate ratio of taxable corporate bonds. These corporate equivalents are typically [[interest rate swap]]s referencing [[Libor#Libor-based derivatives|Libor]] or [[Securities Industry and Financial Markets Association|SIFMA]].<ref>{{Cite web|url=http://www.investinginbonds.com/story.asp?id=351|title = About This Site}}</ref><ref>{{Cite web|url=http://www.bondmarkets.com/story.asp?id=1157|title = SIFMA}}</ref> The arbitrage manifests itself in the form of a relatively cheap longer maturity municipal bond, which is a municipal bond that yields significantly more than 65% of a corresponding taxable corporate bond. The steeper slope of the municipal [[yield curve]] allows participants to collect more after-tax income from the municipal bond portfolio than is spent on the interest rate swap; the carry is greater than the hedge expense. Positive, tax-free carry from muni arb can reach into the double digits. The bet in this municipal bond arbitrage is that, over a longer period of time, two similar instruments—municipal bonds and interest rate swaps—will correlate with each other; they are both very high quality credits, have the same maturity and are denominated in the same currency. Credit risk and duration risk are largely eliminated in this strategy. However, basis risk arises from use of an imperfect hedge, which results in significant, but range-bound principal volatility. The end goal is to limit this principal volatility, eliminating its relevance over time as the high, consistent, tax-free cash flow accumulates. Since the inefficiency is related to government tax policy, and hence is structural in nature, it has not been arbitraged away.

However, many municipal bonds are callable, and this adds substantial risks to the strategy.