Assume you work for a local municipality. Further assume that there are no tax rule restrictions preventing a municipality from buying taxable bonds financed by tax exempt bonds yielding a lower before tax rate of return. What arbitrage strategy should the municipality adopt? When does the opportunity disappear? Once the municipality no longer has arbitrage opportunities, what arbitrage opportunities must exist for taxable investors? When do these opportunities disappear? When will neither tax exempt nor taxable investors face arbitrage opportunities simultaneously? What tax rule restrictions are necessary to prevent this form of clientele based arbitrage?
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