The merger arbitrage strategy seeks to seize the opportunities arising from extraordinary corporate events, such as mergers and acquisitions (M&A) or leveraged buy-outs, by trading the stocks of the companies involved in the deal. In general, in these transactions common stock is exchanged for cash, other common stock, or a combination of cash and stocks. The merger arbitrage strategy is more properly called risk arbitrage, because it is an arbitrage strategy whose outcome purely depends on the risk associated with the deal outcome. Its success totally depends on the finalization of the mergers and acquisitions.
The hedge fund manager takes a directional position on the spread:
• in the case of acquisition, between the value offered for the acquisition and the current market value of the company to be acquired;
• in the case of merger, between the theoretical exchange ratio of the stock of the two merging entities and the exchange ratio currently expressed by the market.
The greater the risk of a deal failure, the greater is the spread. All mergers/acquisitions are exposed to the risk that the deal is not closed as announced initially. If the deal fails, generally the value of the target company shares drops sharply.
The hedge fund manager opens arbitrage positions on mergers and acquisitions where he expects the current market spread to converge towards the offered one. The manager will make a profit if the spread narrows, and will lose money if the spread widens. ...