Risk arbitrage is a type of event-driven investing in that it attempts to exploit pricing inefficiencies caused by a corporate event.
As compensation, the target will receive cash at a specified price, the acquirer's stock at specified ratio, or a combination of the two.
The size of the spread positively correlates to the perceived risk that the deal will not be consummated at its original terms.
[3] Cornelli and Li contend that arbitrageurs are actually the most important element in determining the success of a merger.
[4] In their study, Cornelli and Li found that the arbitrage industry would hold as much as 30%-40% of a target's stock during the merger process.
These activist investors initiate sales processes or hold back support from ongoing mergers in attempts to solicit a higher bid.
[5] One set of passive arbitrageurs invests in deals that the market expects to succeed and increases holdings if the probability of success improves.
This set of arbitrageurs will invest in deals in which they conclude that the probability of success is greater than what the spread implies.
[4] In this case, using the assumption that a higher arbitrageur presence increases the probability of consummation, the share price will not fully reflect the increased probability of success and the risk arbitrageur can buy shares and make a profit.
Its profits materialize if the spread, which exists as a result of the risk that the merger will not be consummated at its original terms, eventually narrows.
A price cut would lower the offer value of the target's shares, and the arbitrageur could end up with a net loss even if the merger is consummated.
These reasons may include either party's inability to satisfy conditions of the merger, a failure to obtain the requisite shareholder approval, failure to receive antitrust and other regulatory clearances, or some other event which may change the target's or the acquirer's willingness to consummate the transaction.
A collar occurs in a stock-for-stock merger, where the exchange ratio is not constant but changes with the price of the acquirer.
The exchange ratio is commonly determined by taking the average of the acquirer's closing price over a period of time (typically 10 trading days prior to close), during which time the arbitrageur would actively hedge his position in order to ensure the correct hedge ratio.
[8] A study conducted by Baker and Savasoglu, which replicated a diversified risk arbitrage portfolio containing 1,901 mergers between 1981 and 1996, experienced a break rate of 22.7%.
[3] Maheswaran and Yeoh examined the risk-adjusted profitability of merger arbitrage in Australia using a sample of 193 bids from January 1991 to April 2000; the portfolio returned 0.84% to 1.20% per month.