Merger or Risk Arbitrage Overview
Introduction to Merger Arbitrage
Merger arbitrage, also known as risk arbitrage, is an event driven trading strategy that attempts to exploit the market price spreads of equities during the merger process.
When one corporation announces plans to purchase another corporation, the target corporation’s market price normally increases to a price slightly below the offer price.
Because the merger announcement does not guarantee that an actual merger will occur, the market price is normally discounted slightly lower than the offer price. Merger arbitrage is the process of assessing and managing this risk to profit from the potential of the spread diminishing when the market price ultimately reaches the offer price. Merger arbitragers bet that deals will go and profit as spreads decrease.
Merger Arbitrage Strategy
Merger arbitrage centers on capturing the market price spread in exchange for bearing risk. The central risk is deal risk. Deal risk is the risk that the announced merger will not actually take place. Mergers can fail for numerous reasons. Common sources of deal risk are failure to obtain shareholder approval for a deal, failure to meet regulatory or antitrust requirements, and the influence of unplanned macro factors.
Individuals or funds engaging in merger arbitrage do extensive research to analyzer deal risk. For example, many merger arbitrage funds consult with lawyers to analyze legal framework of mergers, conduct fundamental analysis on the specific companies, and carry out macro analysis on general factors that could impact mergers.
If merger arbitragers determine the risk/reward characteristics are favorable in a stock for stock deal, they will go long the stock of the target corporation and short the stock of the acquiring corporation. This locks in the spread between the market prices and isolates exposure to the deal outcome. If the merger occurs, the merger arbitrager will profit as the long position of the target corporation is converted into stock of the acquiring corporation. This new acquiring corporation stock will then be used to cover the short position on the acquiring corporation.
In a cash merger, merger arbitragers purchase the stock of the target corporation if the risk/reward characteristics are favorable. If the merger occurs, the merger arbitragers will profit as the target corporation share price increases to the deal price.
Merger Arbitrage Funds
Because successful merger arbitrage usually involves extensive research and analysis, many investors choose to utilize funds to engage in merger arbitrage. There are some merger arbitrage mutual funds, but most mutual funds do not utilize the strategy because they are prohibited from having short positions. Also, most of these merger arbitrage mutual funds have high fees.
Less regulated hedge funds dominate the merger arbitrage fund world. Merger arbitrage hedge fund managers attempt to reduce risk by diversifying across multiple mergers in many different markets. In addition, many merger arbitrage hedge funds will utilize other alternative investments, such as options, to hedge against other risks.
Merger arbitrage funds have low correlations to the general stock market because the funds focus on specific deals and are less influence by macro market factors.
Related Sites:
Merger Arbitrage: Evidence of Profitability
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