Arbitrage is a type of trading strategy in finance that involves purchasing an asset and then selling it in another market, making a profit. This can also refer to a strategy in which two similar assets are purchased and sold simultaneously, because the trader believes their prices don't reflect their true value. The trader can make a profit when there is a price correction.
There are many types of arbitrage. One is merger arbitrage. Another is risk arbitrage. This strategy allows traders to gain from mergers and takeovers between companies.
Risk arbitrage, also known as merger arbitrage, is an event-driven investment strategy that allows traders the opportunity to profit from differences in stock prices prior and after a merger. First, let's look at what happens when two companies merge.
What happens to stock prices for the two companies that are merged?
The stock price of a target company tends to appreciate when a company announces its intention to buy or merge with another company. The stock price of the target company, despite its appreciation, is still below the acquisition price. This is due to uncertainty in the market about whether or not the merger will happen.
Let's take a look at an example that illustrates this point more. In 2016, Microsoft announced that it would purchase LinkedIn and sell the shares for $196. The share price of LinkedIn rose from $131 to $192 on the date of the announcement. It remained below $196, however. This is due to market uncertainty.
Now you know what happens to the share prices of companies that are involved in a merger. How do these events work as merger arbitrage opportunities for you? Let's dive into the details. There are two types of mergers: stock-for-stock and cash. The merger arbitrage possibilities will vary depending on the type of merger.
Cash mergers are where the acquiring company buys the shares of the target for cash. This is a premium. As we have seen, this is the acquiring cost. Here's how traders make money from this situation.
Let's say that company A wants to acquire company B for Rs. 200 per share
Company B shares are currently trading at Rs. 60
- The share price of company A rises to Rs. on the date of the announcement. 160
- On the date of the announcement at Rs. 160, a trader who intends to take advantage of the merger arbitrage opportunities buys shares from company B. 160 per share
- When the merger is completed successfully, the share price for company B rises up to Rs. 200
The trader earns Rs. 40 per share
However, experts consider this strategy less arbitrage and more speculation. The concept of risk arbitrage becomes more apparent in a stock-forstock merger.
Stock-for-stock mergers are where the target company buys the target company and offers its shares to shareholders at a predetermined percentage. This is how a trader can spot and exploit merger arbitrage opportunities.
- The trader buys shares of the target firm and short-sells them to the acquiring firm.
- This creates an area of spread that narrows as the merger deal is completed.
- The acquisition company's equity is diluted by the increase in shares. The trader makes a profit by short-selling these shares.
- The share price rises for the target company.
This price rise is a profit for the trader because they have a long position.
Active or passive risk arbitrage is possible. An investor who holds significant shares in the target company is called active arbitrage. This can often be enough to have an impact on the outcome of the merger. Passive arbitrage occurs when a trader doesn't have enough investment in the target firm to influence the merger.