Risk Arbitrage Mechanics
Risk arbitrage in its general connotation relates to trading around corporate events that alter the capital structure of a firm. Note that we have introduced two terms, capital structure and corporate events. Let us briefly describe what they mean, starting with capital structure. When a business wants to raise initial capital to finance its operation, it can generally do it two ways. One way is to borrow money from lenders and pay interest on the borrowed capital. This approach is also called issuing bonds or issuing debt. The other approach is to promise a percentage ownership in the business commensurate with the fraction of capital invested. This is known as issuing equity. A firm may choose to go entirely one route or alternately issue equity for some portion of the capital and issue debt for the remainder. The percentage of debt and equity that comprise the firm’s capital is termed capital structure. It is important to note that the study of capital structure and its impact on firm value is a vast subject area in itself. However, for our purpose, the simplistic definition will suffice. We now move on to Corporate event. A corporate event may be described as an action undertaken by a company that affects its shareholders and/or bondholders. Typical corporate events could be paying of dividends, stock splits, tender offers, mergers, exchange offers, spinoffs, and recapitalizations. Of these events, the paying of dividends ...