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1.
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Definition
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This strategy involves
transaction-specific analysis seeking to profit by acquiring
securities which are discounted from the value to be paid for them
in a proposed merger or acquisition due to the uncertainty of
transaction timing and completion. The difficulty is in analyzing
the risk of delay or non-completion and determining when during the
period from the commencement of a proposed merger or acquisition to
the conclusion (successful or unsuccessful) of the transaction it is
most efficient — on a present value basis — to take a position.
Risk/merger arbitrage Portfolio Managers typically seek speculative
profits from the purchase of shares in forecasted acquisition
targets, while maintaining defensive positions through hedges in
acquiring companies and disciplined risk management.
Other Resources:
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Princeton University:
S: (n) risk arbitrage, takeover arbitrage (arbitrage involving
risk; as in the simultaneous purchase of stock in a target
company and sale of stock in its potential acquirer.
More…
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Investor Force:
Merger Arbitrage, sometimes called
Risk Arbitrage, involves investment in corporate events, mergers
and hostile takeovers.
More…
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2.
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Examples, Types, or
Variations
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Two
principal types of merger are possible:
In a cash merger, an acquirer proposes to purchase the shares of the
target for a certain price in cash. Until the acquisition is
completed, the stock of the target typically trades below the
purchase price. An arbitrageur buys the stock of the target and
makes a gain if the acquirer ultimately buys the stock.
In a stock for stock merger , the acquirer proposes to buy the
target by exchanging its own stock for the stock of the target. An
arbitrageur may then short sell the acquirer and buy the stock of
the target. This process is called "setting a spread". After the
merger is completed, the target's stock will be converted into stock
of the acquirer based on the exchange ratio determined by the merger
agreement. The arbitrageur delivers the converted stock into his
short position to complete the arbitrage.
If that were all there was to it, then everyone would do it
immediately, and any possible gain would disappear very quickly. But
there is always a risk that the deal will not go through or the
closing will be delayed. Obstacles 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. Such possibilities put the risk in the term risk
arbitrage.
Additional complications can arise in stock for stock mergers when
the exchange ratio is not constant but changes with the price of the
acquirer. These are called "collars" and arbitrageurs use
options-based models to value deals with collars. In addition, 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.
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3.
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Formula
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4.
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Related Terms
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5.
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As
Used in the Hedge Fund World
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In terms of hedge fund strategies,
risk arbitrage shares some properties with other forms of arbitrage
such as relative value, volatility arbitrage, convertible arbitrage,
and statistical arbitrage, but it is also an example of an event
driven strategy.
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6.
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Applications
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7.
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Misused
& Abused
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8.
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Additional Sources of Information
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Books
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News
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Scholarly Papers
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