Risk arbitrage

Risk arbitrage, also known as merger arbitrage, is a hedge fund investment strategy that speculates on the successful completion of mergers and acquisitions. An investor that employs this strategy is known as an arbitrageur. Risk arbitrage is a type of event-driven investing in that it attempts to exploit pricing inefficiencies caused by a corporate event.

A merger begins when one company, the acquirer, makes an offer to purchase the shares of another company, the target. As compensation, the target will receive cash at a specified price, the acquirer's stock at specified ratio, or a combination of the two.

In a cash merger, the acquirer offers to purchase the shares of the target for a certain price in cash. The target’s stock price will most likely increase when the acquirer makes the offer, but the stock price will remain below the offer value. In some cases, the target's stock price will increase to a level above the offer price. This would indicate that investors expect that a higher bid could be coming for the target, either from the acquirer or from a third party. To initiate a position, the arbitrageur will buy the target's stock. The arbitrageur makes a profit when the target's stock price approaches the offer price, which will occur when the likelihood of deal consummation increases. The target's stock price will be equal to the offer price upon deal completion.

In a , the acquirer offers to purchase the target by exchanging its own stock for the target's stock at a specified ratio. To initiate a position, the arbitrageur will buy the target's stock and short sell the acquirer's stock. This process is called "setting a spread". The size of the spread positively correlates to the perceived risk that the deal will not be consummated at its original terms. The arbitrageur makes a profit when the spread narrows, which occurs when deal consummation appears more likely. Upon deal completion, the target's stock will be converted into stock of the acquirer based on the exchange ratio determined by the merger agreement. At this point in time, the spread will close. The arbitrageur delivers the converted stock into his short position to close his position.

The risk-return profile in risk arbitrage is relatively asymmetric. There is typically a far greater downside if the deal breaks than there is upside if the deal is completed.

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