Risk arbitrage

Risk arbitrage, or merger arbitrage, is an investment or trading strategy often associated with hedge funds.

Related Topics:
Investment - Hedge fund

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Two principal types of arbitrage are possible:

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In a cash merger, an acquirer proposes to purchase the shares of the target for a certain price in cash. Before the aquisition is completed, the stock of the target trades below the purchase price. An arbitrageur buys the stock of the target and makes a gain if the acquirer ultimately buys the stock.

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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 will then short sell the acquirer and buy the stock of the target. After the merger is completed, the target's stock will be converted into stock of the acquirer. The arbitrageur delivers the converted stock into her short position to complete the arbitrage.

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If that were all there was to it, then everyone would do it immediately, and any possible gain would disappear very quickly. But there is more to it, the risk that the deal won't go through, because of opposition from the target company's board members, or antitrust or regulatory authorities, or a change of heart on the part of the acquirer's board, or for any other cause. Such possibilities put the risk in the term risk arbitrage.

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Additional complications can arise in stock for stock mergers when the exchange ratio is not constant but changes with the price of the acquirer.

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When hedge fund strategies are sorted into categories, risk arbitrage is sometimes included with other forms of arbitrage. But it can also be included as one among the event driven strategies.

Related Topics:
Arbitrage - Event driven

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