Risk arbitrage
Encyclopedia
Risk arbitrage
, or merger arbitrage, is an investment
or trading strategy often associated with hedge fund
s.
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.
, 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, this offsets the even percentage. Now, a player that 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 may be easily illustrated that there is a chance that the acquisition may not be completed, and in this 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 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.
Arbitrage
In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices...
, or merger arbitrage, is an investment
Investment
Investment has different meanings in finance and economics. Finance investment is putting money into something with the expectation of gain, that upon thorough analysis, has a high degree of security for the principal amount, as well as security of return, within an expected period of time...
or trading strategy often associated with hedge fund
Hedge fund
A hedge fund is a private pool of capital actively managed by an investment adviser. Hedge funds are only open for investment to a limited number of accredited or qualified investors who meet criteria set by regulators. These investors can be institutions, such as pension funds, university...
s.
Two principal types of merger
Mergers and acquisitions
Mergers and acquisitions refers to the aspect of corporate strategy, corporate finance and management dealing with the buying, selling, dividing and combining of different companies and similar entities that can help an enterprise grow rapidly in its sector or location of origin, or a new field or...
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
Short selling
In finance, short selling is the practice of selling assets, usually securities, that have been borrowed from a third party with the intention of buying identical assets back at a later date to return to that third party...
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
Antitrust
The United States antitrust law is a body of laws that prohibits anti-competitive behavior and unfair business practices. Antitrust laws are intended to encourage competition in the marketplace. These competition laws make illegal certain practices deemed to hurt businesses or consumers or both,...
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
Arbitrage
In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices...
such as relative value, volatility arbitrage
Volatility arbitrage
In finance, volatility arbitrage is a type of statistical arbitrage that is implemented by trading a delta neutral portfolio of an option and its underlier. The objective is to take advantage of differences between the implied volatility of the option, and a forecast of future realized volatility...
, convertible arbitrage
Convertible arbitrage
Convertible arbitrage is a market-neutral investment strategy often employed by hedge funds. It involves the simultaneous purchase of convertible securities and the short sale of the same issuer's common stock....
, and statistical arbitrage
Statistical arbitrage
In the world of finance and investments, statistical arbitrage is used in two related but distinct ways:* In academic literature, "statistical arbitrage" is opposed to arbitrage. In deterministic arbitrage, a sure profit can be obtained from being long some securities and short others...
, but it is also an example of an event driven strategy.
Risk arbitrage simplified
Imagine you are a gambler that "plays" the odds. That in a nutshell sums up the essence of this term. In a game of rouletteRoulette
Roulette is a casino game named after a French diminutive for little wheel. In the game, players may choose to place bets on either a single number or a range of numbers, the colors red or black, or whether the number is odd or even....
, 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, this offsets the even percentage. Now, a player that 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
Public company
This is not the same as a Government-owned corporation.A public company or publicly traded company is a limited liability company that offers its securities for sale to the general public, typically through a stock exchange, or through market makers operating in over the counter markets...
at $50.00 per share, and "Sam's" taco shop moved to take over
Takeover
In business, a takeover is the purchase of one company by another . In the UK, the term refers to the acquisition of a public company whose shares are listed on a stock exchange, in contrast to the acquisition of a private company.- Friendly takeovers :Before a bidder makes an offer for another...
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 may be easily illustrated that there is a chance that the acquisition may not be completed, and in this 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 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.
External links
- ArbitrageView.com - Risk arbitrage opportunities in the U.S. Markets
- Merger Arbitrage Defined - Precise definition of merger arbitrage and risk
- Merger Arbitrage Investing - Guide to Merger and Risk Arbitrage Investing