The Risk Arbitrage Strategy

The risk arbitrage strategy is one that arbitrageurs take on when they look to make a profit on the spread between share prices, in the event of a merger. It is quite an ironic type of arbitrage, since theory usually suggests that arbitrage is supposed to include the words, ‘risk-free,’ in its definition.

Two Types of Mergers

There are two main types of mergers: a cash merger and a stock merger. Simply enough, a cash merger is when a company that wants to acquire another company (the acquirer) proposes a price and then pays cash for all of that company’s stock. Before the actual transaction is completed, an arbitrageur can buy some stock from the company that is going to be acquired. When the transaction is finally completed, the arbitrageur will make a profit on the spread between the price he paid and the new proposed price from the acquirer. In a stock merger, the acquirer will propose to exchange its own stock for a target company’s stock. In this case, an arbitrageur might short the stock of the acquirer and buy the stock of the target company. When the merger transaction has been completed, the stock from the target company will be converted into stock of the acquiring company determined by an exchange ratio from the contract of the merger. This converted stock can then be used to return on the original short sale.

Risk

Risk arbitrage, as the name implies, carries along certain risks with it. There are many reasons why a merger might fail to go through. If one party cannot satisfy certain requirements of the merger, then the deal might be thrown out. Other reasons include failure to get shareholder approval, failure to receive legal authorization, or changes in the market. For example, some companies might claim that a merger will cause a monopoly in a certain industry because of the size of the two participating companies, and advocate that the merger should not be legally sanctioned.

Example

You, as an arbitrageur, notice that Company A is publicly trading at $10 per share, and Company B makes an offer to take over Company B for a price of $15 dollars per share. You simply buy 10 shares of Company A and immediately sell them to Company B for $15 dollars per share, making instant profit of $5 per share.

In Practice

The reality is that as soon as an offer is made, there will be a very short window of opportunity to buy stock from Company A before the price is driven up by all of the sudden demand. This is why, realistically, an arbitrageur might decide to incorporate a tactic of speculation and predict a merger days or months ahead of time before all of the demand that will come after an announcement. Obviously by incorporating more speculation, you take on more risk but more risk is usually followed by more profit potential. If an arbitrageur decides to try after an announcement he might still make a profit, but a much smaller one.

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