Risk Arbitrage, 2nd Edition

CHAPTER 4Estimating the Return on a Risk Arbitrage Position

Investors are always keenly interested in what they can potentially earn on their investment. Arbitrageurs are no different. In fact, an analysis of an arbitrage transaction generally results in a more quantitative estimate of return than is achieved through a traditional analysis of a stock or bond position. Security analysts usually come up with a range of values for a given equity security. These estimates are generally the basis for their recommendation to buy, hold, or sell. Risk arbitrage analysis yields a more defined value of a security, based on the arbitrageur's estimate of “deal value”—the first step toward an estimate of return on a risk arbitrage position. This return becomes the initial key element in the arbitrageur's analysis framework.

SIMPLE DEALS

Some deals are simple transactions on which it is easy to calculate return. For instance, suppose Company A is purchasing Company T in a friendly cash tender offer. The tender‐offer price is $20. This means that the acquiring company, Company A, is paying $20 for each share of stock of the target company, Company T. The deal price is $20, and we will assume that the transaction will close in approximately one month (30 days).

If Company T's stock is trading at $19.85 per share, we may calculate the return on the deal as follows:

where    ERUL