A Detailed Merger Arbitrage Case

Merger arbitrage is defined as the opportunity to profit amidst a merger or acquisition between two companies. During the merger, the target company that is being acquired will trade at a discount. In this way, it offers the ability to profit from the difference between the discount and the target price. This target price is stated in the terms of the merger. The arbitrage profit is available because it is not certain when the merger will be finalized and even if the merger will happen at all.

Funds of funds & Hedge funds strategies

This sort of arbitrage is complex but is profitable most of the time. It often provides twenty percent, or more, rates of return. Hedge funds use this strategy along with many other arbitrage strategies. Funds of funds are growing more and more popular because of their top down focus and ability to leverage great talent. They ultimately offer this to the retail investing public. Lately, the industry has seen funds of funds carry hedge funds within their portfolios giving a greater diversity to this category. Most funds of funds portfolios are found in major mutual funds and sub accounts in life insurance investments and are normally the largest, based on assets under management.

Merger arbitrage variables

You need to know what the target price is and when the merger should be finalized. The profitability of the arbitrage is based on the following variables:

  • Time before closing
  • Target price discount

The market price will have a built-in discount to the target price because of this uncertainty. Also, the degree of profitability depends on the time before closing. Sometimes the merger takes longer than initially expected and sometimes the merger doesn’t happen at all. This all plays a role in the complexity of this arbitrage strategy.

What is arbitrage?

In this case, arbitrage can be defined as the difference between the current price of the target company and price designated for the closing of the deal, the target price. This is the price that has been stipulated in the terms of the merger or acquisition. Arbitrage can also be defined as the extraordinary profit achieved while bearing a disproportionate amount of risk.

In this case, the risk entails the free floating market prices of the two companies. That means that the execution of this strategy is important and requires a sophisticated expertise. Normally, arbitrage is the risk-free profit that is available to those who find inefficiencies in the market. The theory holds that markets are not always efficient. Therefore, there exists opportunities that will give the investor, or arbitrageur, the ability to profit above and beyond the utility of risk that is presented. As arbitrageurs enter the market, however, the markets will veer on towards being fully efficient leaving little to no arbitrage opportunity left. Those who follow this theory believe that markets are efficient.

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