Pairs Trading: Quantitative Methods and Analysis

CHAPTER 12

Spread Inversion

INTRODUCTION

In Chapter 11 we discussed that the risk neutral probabilities of merger can be evaluated from the value of the spread as observed in the marketplace. The reasoning was that market forces that affect the value of the spread take into account the risk of deal completion. It is probably true that in most cases the deal completion risk is the predominant factor affecting the spread dynamics. However, the spread is also subject to idiosyncratic movement on the part of any one of the two stocks in question. This movement can be due to a variety of reasons that have nothing to do with the deal completion risk and hence contributes to what we shall term noise in the evaluation of the spread-implied probabilities. This fact is rather evident from the raw plot of the spreads.

Some of the reasons for this behavior could be due to the bid-ask spread of the individual stocks and the order of the buys and sells as they occur on each individual stock. It could also be due to the market maker, looking to adjust inventory. The market maker may move the price sufficiently higher or lower albeit on a temporary basis to produce the desired supply or demand in the stock and thereby adjust his inventory levels. Another reason for the spread movement could be attributed to short covering on the target stock especially right after the merger announcement. Therefore, when attempting to evaluate the deal break probabilities, we need to bear in mind that the ...