The goal of risk arbitrage, also referred to as merger arbitrage, is to make money when the difference between the stock’s trading price and the acquirer’s estimated value in a planned takeover deal gets smaller. Risk arbitrage in a stock-for-stock merger entails purchasing shares of the target and shorting shares of the acquirer. If the deal is completed, this investment plan will be profitable. The investor will suffer financial loss if it is not.

A takeover investment strategy is known as “risk arbitrage” enables an investor to benefit from the discrepancy between the stock’s trading price and the acquirer’s valuation.

The stock price of the acquiring company typically drops after it announces its intention to acquire the target company, while the stock price of the target company typically increases.

A risk arbitrage investor would purchase shares of the target company in an all-stock offer while simultaneously shorting shares of the acquirer.

This strategy exposes the investor to the risk of the takeover deal failing, which could result in financial losses for the investor.

Understanding Risk Arbitrage

When an acquisition and merger (M&A) deal is revealed, the stock price of the target company soars towards the acquirer’s valuation. The three financing options the acquirer will suggest are all cash, all stock, or a mix of cash and stock forward.

The target’s stock price will trade close to or at the acquirer’s valuation price in an all-cash transaction. In some cases, the target’s stock price will be higher than the offer price since the market may believe that the target will be sold to a higher bidder or that the target’s shareholders and board of directors won’t accept the cash offer price at its current level.

However, there is typically a difference between the buyer’s offer price and the target’s trading price immediately following the deal announcement. If the market believes that the deal won’t close at the offer price or that it might not close at all, this spread will form. Since the investor is simply going long the target stock in the hopes or expectations that it will rise towards or meet the all-cash offer price, purists do not consider this to be risk arbitrage. Those who define “arbitrage” broadly would point out that the investor is attempting to profit from a momentary price difference.

Risk Arbitrage and All-Stock Offers

However, there is typically a difference between the buyer’s offer price and the target’s trading price immediately following the deal announcement. If the market believes that the deal won’t close at the offer price or that it might not close at all, this spread will form. Since the investor is simply going long the target stock with the hopes or expectations that it will rise towards or meet the all-cash offer price, purists do not consider this risk arbitrage. Those who define “arbitrage” broadly would point out that the investor is attempting to profit from a momentary price difference.

The stock price of the target company, however, frequently stays below the announced acquisition valuation. A “risk arb” (as this type of investor is referred to colloquially) purchases shares of the target company in an all-stock offer while also short-selling shares of the acquirer. The risk arbitrator can use the converted stock to cover his short position if the deal is completed and the target company’s stock is converted into the stock of the acquiring company. For a deal involving cash and stock, the risk arb’s play becomes slightly more complex, but the basic principles remain the same.

Options can also be used for risk arbitrage. The investor would put options on the stock of the acquiring company and buy shares of the target company’s stock.

Criticism of Risk Arbitrage

Risk arbitrage exposes the investor to the significant risk that the deal will be canceled or rejected by regulators. Other factors, such as either company’s financial instability or a tax situation that the acquiring company deems unfavorable, could cause the deal to fall through. The usual outcome if the deal falls through for any reason would be a drop—possibly sharp—in the target’s stock price and an increase in the prospective acquirer’s stock price. Losses will result for an investor who is long the shares of the target and short the shares of the acquirer.

How to Make Money With Risk Arbitrage Trading

Are you interested in making money by trading stocks that are in the news for mergers and acquisitions?

The best strategy might be risk arbitrage. Risk arbitrage is an event-driven speculative trading strategy, also referred to as merger arbitrage trading. By taking a long position in the stock of a target firm and, if desired, combining it with a short position in the stock of the acquiring company to create a hedge, it aims to make money.

Risk arbitrage is a sophisticated trading technique that is typically used by hedge funds and quantitative specialists. Although it can be used by individual traders, experienced traders are advised to use it because of the high level of risk and unknowns it entails.

The risk-return profile, likely scenarios for risk arbitrage opportunities, but also how traders can profit from risk arbitrage are all explained in this article with the help of a thorough example.

A long position in the stock of a target company is taken as part of the event-driven speculative trading strategy known as risk arbitrage in an effort to make money.

In order to create a hedge, risk arbitrage may also pair this long position with a short position in the stock of a target company.

Due to its high level of risk & inherent uncertainty, risk arbitrage is only advised for seasoned traders.

What is a Merger?

In a merger, one business, the acquirer, offers to buy the stock of another business, the target. The target will be compensated with cash at a predetermined price, shares of the acquirer’s stock at a predetermined ratio, or a combination of the two.

In a cash merger, the acquirer makes an offer to pay a specific amount in cash to buy the target company’s shares. When the acquirer makes the offer, the target’s stock price will probably rise, but it will still be less than the value of the offer. On occasion, the offer price will be exceeded by the stock price of the target. This would suggest that investors anticipate the target may receive a higher offer in the future, either from the acquirer or from a different party. The arbitrageur will purchase the target’s stock to open a position. When the target stock price approaches the bid amount, which will happen as the likelihood of the deal closing rises, the arbitrageur will profit. The target’s stock price will be equal to the offer price upon deal completion.

In a stock merger, the acquirer makes an offer to buy the target by exchanging a predetermined ratio of its own stock for the target’s stock. The arbitrageur will short-sell the stock of the acquirer and buy the stock of the target to start a position. This procedure is known as “setting a spread”. The perceived risk that the deal won’t close at its original terms is positively correlated with the size of the spread. When the spread narrows, which happens when deal completion seems more likely, the arbitrageur makes money. At closing, the acquirer’s stock will be converted from the target’s stock based on the exchange ratio specified in the merger agreement. The spread will then close at this time.

Active vs. passive risk arbitrage

The arbitrageur has the option of producing returns actively or passively. Active arbitrageurs buy enough shares of the target company to influence the merger’s outcome. In an effort to entice a higher offer, these activist investors start sales processes or withhold support from ongoing mergers. On the other extreme, passive arbitrageurs have no impact on the merger’s outcome. One group of passive arbitrageurs makes investments in transactions that the market anticipates will be profitable and increases holdings when the likelihood of profitability rises. The second category of passive arbitrageurs is more active but still passive: these arbitrageurs are pickier about their investments and rigorously test presumptions regarding the risk-reward profile of particular deals.

This group of arbitrageurs will invest in transactions where they believe there is a higher chance of success than what the spread suggests. In highly liquid stocks, passive arbitrageurs have more freedom because they can better conceal their trades the more liquid the target stock is. In this instance, assuming that a greater arbitrageur presence increases the likelihood of consummation, the share price will not accurately reflect the increased likelihood of success, allowing the risk arbitrageur to purchase shares and profit. The arbitrageur has to choose whether playing an active or passive role in the merger is the more desirable course of action in a specific circumstance.

Risk return profile

In risk arbitrage, the risk-return profile is somewhat asymmetric. Usually, the downside of the deal failing is much greater than the benefit of it succeeding.

Deal-level risks

Risk-free “arbitrage” carries some risk. If the spread eventually narrows, which happens as a result of the risk that the merger won’t be completed at its original terms, it makes money. Deals having a chance of falling through or not being completed in the timeframe originally planned pose a risk. The risk arbitrager must be aware of the dangers to the deal’s original terms and eventual completion. Price reductions, deal extension risk, and deal termination are some of these risks. Even if the merger goes through, a price reduction would reduce the offer value of the target’s shares, leaving the arbitrageur with a net loss.

If the likelihood of the deal closing stays constant, an unexpected delay in the completion date lowers the expected annualized return, which in turn results in decline in the stock to make up for it. The majority of acquisitions and mergers however are not changed. As a result, the arbitrageur need only worry about whether the deal will be completed in accordance with its original terms or canceled. There are numerous reasons for deal termination. These factors could be either party’s inability to meet the merger’s requirements, the failure to secure the necessary shareholder approval, the lack of antitrust as well as other regulatory clearances, or some other circumstance that might alter the target’s or the acquirer’s willingness to complete the deal. Such possibilities put the risk in the term risk arbitrage.

Deal by deal, different issues might come up. One illustration is collared. In a stock-for-stock merger, a collar develops because the exchange ratio fluctuates in response to the acquirer’s price. Arbitrageurs evaluate collar deals using models based on options. The acquirer’s closing price is typically averaged over a period of time (typically 10 trading days prior to close) to determine the exchange ratio, during which the arbitrageur would actively hedge his position to ensure the proper hedge ratio.

An 8.0% break rate was observed in a 2010 study of 2,182 mergers that took place between 1990 and 2007. A study by Baker and Savasoglu found a break rate of 22.7% when they replicated a diversified risk arbitrage portfolio with 1,901 mergers between 1981 and 1996.

Market risk

According to a number of authors, in typical market environments, the returns from risk arbitrage are largely unrelated to the returns from the stock market. Risk arbitrage, however, is not always insensitive to the stock market’s performance across the board. The beta (finance) between merger arbitrage returns & risk arbitrage returns can rise to 0.5 when the stock market experiences a decline of 4% or more. This indicates that the exposure to market risk is asymmetrical: the arbitrageur tends to lose money during market downturns but does not participate in market rallies.