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auction rate security (ARS)

A type of long-term bond, issued by a corporation or a municipality. ARSs differ from traditional bonds in one crucial respect: rather than paying a fixed rate of interest for a long time (e.g., a minimum of 10 and sometimes as long as 30 years), the interest rate on an ARS "resets" frequently through a process known as a Dutch auction, which takes place every 7, 28, or 35 days. At each Dutch auction, ARS holders are given an opportunity to sell the ARS. Issuers/borrowers of an ARS benefit because ARSs can provide them with long-term financing, but at substantially lower rates, compared to traditional long-term bonds. Buyers of ARSs benefit because, given their short-term nature, an ARS offers the liquidity of a money market fund, yet with a higher rate of return. But in February of 2008, a number of Dutch auctions "failed" due to a lack of buyers, an event that caused ARS investors' money to be frozen in their accounts. As a result, many investors brought class action lawsuits against the banks and brokerages that induced them to invest in ARSs.

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