Interested in generating money by trading companies that are making news in mergers and acquisitions? Risk arbitrage may be the best option.
Risk arbitrage, often known as merger arbitrage trading, is an event-driven speculative trading approach. It seeks to make profits by establishing a long position in a target company’s stock and perhaps combining it with a short position in an acquiring company’s stock to construct a hedge.
Risk arbitrage is a sophisticated trading method used mostly by hedge funds and quantitative specialists. Individual traders may use it, but because to the high amount of risk and uncertainty involved, it is best suited for professional traders.
This article illustrates how risk arbitrage trading works, the risk-return profile, possible situations for risk arbitrage possibilities, and how traders may gain from risk arbitrage using a thorough example.
- Risk arbitrage is an event-driven speculative trading technique that seeks to benefit by holding a long position in a target company’s shares.
- To establish a hedge, risk arbitrage may combine this long position with a short position in the shares of an acquiring business.
- Due to the significant amount of risk and uncertainty inherent in the technique, risk arbitrage is only suggested for experienced traders.
How Risk Arbitrage Trading Works
Assume that TheTarget, Inc. closed at $30 per share last evening, and TheBigAcquirer, Inc. made an open offer to purchase it at a 20% premium—for $36 per share. This news is immediately reflected in TheTarget’s morning opening pricing, and its shares will trade around $36.
Deal risk is always present in merger and acquisition (M&A) situations. The transaction may fail for a number of reasons, including regulatory hurdles, political concerns, economic events, or the target business rejecting the offer (or receives counter-offers from other bidders).As a result, TheTarget’s pricing will be lower than the offer price of $36, say $33, $34, $35.50, and so on. The closer it is to the offer price, the more likely the sale will close.
There is also the possibility that the trading price may rise above the offer price of $36. This may occur when there are numerous prospective acquirers and there is a good chance that another bidder(s) will put a greater offer. Nonetheless, the price would most certainly settle at a level somewhat lower than the final highest offer. So let’s start with the first scenario: the trade price is less than $36.
Assume the price of TheTarget rises from $30 to the offer price of $36. The risk arbitrage trader takes advantage of the chance at $33 per share. After all of the required regulatory procedures are completed in three months, the sale is finalized at $36. In three months, the trader achieves a profit of $3 per share, or 9.09%—roughly 37% annualized profit.
Hedge Acquiring Company Stock
In actuality, along with TheTarget company’s price increase, TheBigAcquirer company’s share price often falls. The purchasing corporation will face the expense of financing the purchase, paying the price premium, and integrating the target business into the bigger entity. In essence, the acquirer profits at the cost of the target.
If TheBigAcquirer’s share price falls from $50 to $48 following this offer, the trader may enter a short position at $49, for example. It gains $1 per share, or 2% in three months—roughly 8% annualized earnings.
Profits from combined long and short trades add up to (3+1)/(33+49) = 4.87% in three months—or 19.51% in total yearly profits.
Other Trade Scenarios for Risk Arbitrage
Other risk arbitrage possibilities exist outside of mergers and acquisitions, such as divestitures, divestitures, new stock issuance (rights issue or stock splits), bankruptcy filings, distress sales, or stock swaps between two firms.
Risk arbitrageurs sometimes have an edge in such scenarios because they supply enough liquidity in the market for trading the equities involved. They purchase what ordinary investors are anxious to sell, and vice versa. Experienced risk arbitrageurs may often charge a premium for supplying much-needed liquidity in such deals.
Such corporate-level changes or transactions take months, quarters, or even more than a year to occur. This might provide possibilities for professional traders who can trade and profit on the same equities several times.
Risks in Arbitrage Trading
Risk arbitrage has a significant potential for profit. However, the amount of the danger is proportional. Here are some risk scenarios that may arise as a consequence of trading activities and other circumstances.
Difficulty in Tracking
Mergers and acquisitions, as well as other business changes, are tough to keep track of on a daily basis. The Efficient Market Hypothesis is widely used in real-world trading, and the effect of news or rumors regarding potential mergers and acquisitions is immediately reflected in stock prices. Traders may find themselves placing positions at unfavourable and severe price levels, with limited potential for profit. Brokerage fees erode on earnings as well.
The possibility that the transaction would fail is referred to as deal risk. Deal risk has several consequences, and risk arbitrage traders must estimate it realistically. This may even include consulting with legal professionals, which raises costs.
If the transaction fails, the target’s and acquirer’s prices will return to their original amounts of $30 and $50, respectively. The trader will lose $3 and $1, totaling a $4 loss. ($3+$1)/($33+$49) = 4.87% in three months, or a 19.51% annualized loss overall.
It is common for an acquirer/bidder to over-price the premium, causing the stock price to decrease. When the acquisition fails, the market applauds the acquirer for avoiding a terrible agreement, and its stock price soars, maybe even higher than before. This might result in a larger loss for the trader who is short on acquirer stock.
Stock Prices Falling
The same situation of transaction failure has a negative impact on the target stock values. Its prices may fall to even lower levels than before the sale, resulting in significant losses.
Another risk issue for transactions on event-driven corporate-level agreements is an unknown timescale. The trading money is committed to the deal for at least a few months, resulting in a loss of opportunity. A few traders also try to profit by initiating complicated positions via the use of derivatives. Derivatives, on the other hand, have expiry dates, which might provide a problem over protracted periods of transaction confirmation.
Risk arbitrage deals are often leveraged, which multiplies the possible gains and losses.
The Bottom Line
The world of mergers and acquisitions is fraught with uncertainty, but risk arbitrage can be a very rewarding strategy for experienced traders who are skilled at capital management and capable of reacting swiftly and efficiently to real-world events.
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