Arbitrage in the world of finance is a kind of trading strategy that involves buying an asset in one market and selling it in another, thereby making a profit from the difference. It can also be used to refer to the strategy where two different but similar assets are bought and sold simultaneously because the trader believes that their prices do not reflect their true values. Eventually, when a price correction occurs, the trader can profit off it.
Among the many kinds of arbitrage, there’s merger arbitrage, which is also known as risk arbitrage. This is a strategy that helps traders gain from mergers or takeovers between two companies.
What is merger arbitrage?
Merger arbitrage or risk arbitrage is a kind of event-driven investing strategy that allows traders to capitalize on the differences in stock prices before and after a merger occurs. To understand what is merger arbitrage and how traders find and spot merger arbitrage opportunities, you need to first get to know what happens when two companies merge.
What happens to the stock prices of the two companies involved in a merger?
Generally, when a company puts forth its intent to purchase or merge with another company, the stock price of the acquiring company mostly tends to decline, while the stock price of the target company often tends to appreciate. But despite the appreciation, the stock price of the target company generally remains below the acquisition price. This difference is a reflection of the uncertainty in the market regarding whether or not the merger will actually come to pass.
Let’s look at an example to illustrate this point better. Back in 2016, Microsoft announced its intention to purchase LinkedIn and offer the shares of LinkedIn for $196. On the date of this announcement, the share price of LinkedIn shot up from around $131 to around $192. But it remained below the acquisition price of $196. This difference or discount reflects the market uncertainty.
How do mergers act as merger arbitrage opportunities?
Okay, so now you’ve seen what happens to the price of the shares of the companies involved in a merger. But how do these events act as merger arbitrage opportunities? Let’s get into those details. Mergers can be any one of two kinds – cash mergers and stock-for-stock mergers. Depending on the kind of merger involved, the merger arbitrage opportunities differ.
What happens in a cash merger?
In a cash merger, the acquiring company purchases the shares of the target company for cash, at a premium. This is the acquiring price, as we’ve previously seen. So, here’s how traders profit off this situation.
- Say a company A plans to acquire company B for Rs. 200 per share.
- The shares of company B are currently trading at Rs. 60.
- On the date of the announcement, the share price of company B rises up to Rs. 160.
- A trader intending to use the merger arbitrage opportunities here purchases the shares of company B on the announcement date at Rs. 160 per share.
- Later, when the merger is successfully completed, the share price of company B rises to Rs. 200.
- So, the trader makes a profit of Rs. 40 per share.
Many experts, however, consider this strategy as less arbitrage and more speculation. In a stock-for-stock merger, the concept of risk arbitrage is more evidently at play.
What happens in a stock-for-stock merger?
In stock-for-stock mergers, the acquiring company purchases the target company by offering its own shares to the shareholders of the target company at a predetermined proportion. Here’s how a trader spots and leverages merger arbitrage opportunities in this kind of merger.
- The trader purchases the shares of the target company and short-sells the shares of the acquiring company.
- This creates a spread, which narrows when the merger deal comes to completion.
- With regard to the acquiring company, the equity is diluted because the number of shares increases. So, the trader profits from short-selling those shares.
- With regard to the target company, the share price increases.
- The trader profits off this rise in price because of the long position taken.
Risk arbitrage can be either active or passive. Active arbitrage occurs when an investor holds a significant portion of the shares in the target company – often enough to influence how the merger turns out. Passive arbitrage is when a trader does not hold enough investment in the target company to sway the merger, and so, is required to make trading decisions based on the probability of how the merger may occur, if at all.