CHAPTER 5Estimating the Risk of Arbitrage Transactions

In Chapter 1, I explained why the term risk is linked to arbitrage. In the Cooper Tire deal described in Chapter 1, arbitrageurs who owned Cooper Tire suffered large losses because the U.S. Federal Court allowed Apollo Tyre to walk away from the previously negotiated friendly merger. After Vice‐Chancellor Glasscock issued his decision in the court, arbitrageurs who owned Cooper Tire shares rushed outside the Court to give instructions to sell their shares. The results were a sharp decline in the price of Cooper Tire and large losses of capital for all Cooper Tire shareholders. Arbitrageurs must estimate and continually monitor the risks they assume when they invest in any risk arbitrage transaction.

ASSESS THE PRICE HISTORY OF THE TARGET COMPANY

The risk estimation process begins with the initial announcement of the deal. Simultaneously with their initial estimate of return, arbitrageurs begin the process of determining what their losses might be if the transaction does not close as planned.

The initial step in analyzing a deal's risk is usually an examination of the trading history of the target company's securities. The arbitrageur generally asks the following questions:

  • Where was the target company's stock (or other related securities subject to the takeover) trading prior to announcement of the transaction?
  • Was there an information leak that generated insider trading prior to the announcement? Did the stock price ...

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