Risk arbitrage

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Risk arbitrage, or merger arbitrage, is an investment or trading strategy often associated with hedge funds.

Two principal types of merger are possible: a cash merger, and a stock merger. In a cash merger, an acquirer proposes to purchase the shares of the target for a certain price in cash. Until the acquisition is completed, the stock of the target typically trades below the purchase price. An arbitrageur buys the stock of the target and makes a gain if the acquirer ultimately buys the stock.

In a stock for stock merger, the acquirer proposes to buy the target by exchanging its own stock for the stock of the target. An arbitrageur may then short sell the acquirer and buy the stock of the target. This process is called "setting a spread." After the merger is completed, the target's stock will be converted into stock of the acquirer based on the exchange ratio determined by the merger agreement. The arbitrageur delivers the converted stock into his short position to complete the arbitrage.

If this strategy were risk-free, many investors would immediately adopt it, and any possible gain for any investor would disappear. However, risk arises from the possibility of deals failing to go through. Obstacles may include either party's inability to satisfy conditions of the merger, a failure to obtain the requisite shareholder approval, failure to receive antitrust and other regulatory clearances, or some other event which may change the target's or the acquirer's willingness to consummate the transaction. Such possibilities put the risk in the term risk arbitrage.

Additional complications can arise in stock for stock mergers when the exchange ratio is not constant but changes with the price of the acquirer. These are called "collars" and arbitrageurs use options-based models to value deals with collars. In addition, the exchange ratio is commonly determined by taking the average of the acquirer's closing price over a period of time (typically 10 trading days prior to close), during which time the arbitrageur would actively hedge his position in order to ensure the correct hedge ratio.

In terms of hedge fund strategies, risk arbitrage shares some properties with other forms of arbitrage such as relative value, volatility arbitrage, convertible arbitrage, and statistical arbitrage, but it is also an example of an event driven strategy.

Risk arbitrage simplified[edit]

Imagine that you are a gambler who plays the odds. That example in a nutshell sums up the essence of risk arbitrage. In a game of roulette, one option is to bet on red numbers or black numbers, which would amount to a fifty-percent chance of an even payout; however, since there are two green numbers, their existence offsets the even percentage. A player who would be betting against the red or black would be playing the substantial odds of hitting green.

Translated to investment: Hypothetically, if Joe's taco shop were publicly traded at $50.00 per share, and Sam's taco shop moved to take over Joe's taco shop at a proposed $65.00 per share, this means Joe's taco shop's shares are instantly worth $65.00 per share. The game comes into play because those same shares are currently trading at only $50.00 per share, should the buyout occur. If the early trades (restricted or non-retail trades) elevate the value up to $60.00 per share, there exists the $5.00 difference. This is the entrance of risk arbitrage. The risk inheres in the chance that the acquisition may not be completed, in which case the price per share will reduce to the original $50.00 per share.

There are many factors that are in play that prevent the individual retail trader from having a chance at capitalizing on different types of arbitrage. Access to the market and the technology required to achieve up-to-the-minute details are usually considered some of the most prominent. [1]

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