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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
Imagine 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 (one in European roulette), 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.
Suppose company A is trading at $40 a share. Then company X announces that they plan to buy it, in which case holders of stock get $80. Then the stock jumps to $70. It does not go to $80 since there is some chance the deal will not go through. Here the odds are 25% that it does not (assuming the stock is worth $40 in that case). The convergence trade is that the deal will go through and the stock really is worth $80. Here the person playing gains $10 if he is right, but loses $30 if he is wrong. The divergence trade is that the deal will not go through. More accurately, it is an overlay in that the odds being offered make the bet worth it (for example, if someone offered odds of 50:1 for roulette).
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.
- Risk Arbitrage - Risk Encyclopedia
- Merger Arbitrage Defined - Precise definition of merger arbitrage and risk
- Published Merger Arbitrage Spreads - Published merger arbitrage spreads
- Event Driven Strategy Outlook: Looking Beyond Merger Arb - Event Driven Strategy Outlook: Looking Beyond Merger Arb