Chapter 5Sources of Risk and Return

The two most important drivers of returns on merger arbitrage are the deal spread and timing of the closing. Both are discussed briefly in Chapter 2 but are be examined more systematically here. For dividend-paying stocks, dividends are also an important element of return and can, in some instances, even be the only return, as in the case of a preferred stock. Additional ways that arbitrageurs can generate returns are interest on the proceeds of short sales and leverage.

Deal Spread

In Chapters 2 and 4, we discussed how to calculate the spread and factor the risk of a collapse into the equation. In a way, the spread calculation is a chicken-and-egg type of situation: The spread exists because there remains risk, and the risk is explained by the existence of a spread.

Some terminology related to spreads has already been introduced in the discussion of Chapter 2. We will clarify some of the terms here.

Spreads can be wide or tight and can become more so if they widen or tighten. “Narrow” is less commonly used to describe tight spreads.

Gross spreads exclude dividends, whereas net spreads are supposed to include dividends and all other costs.

Merger arbitrage spreads are typically very tight in absolute terms. A merger arbitrageur rarely makes large returns. However, the seemingly low returns must be viewed against the short time frame in which the returns can be achieved. Typical merger arbitrage spreads are in the range 2 to 4 percent for ...

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