Risk arbitrage was the original name given to Merger Arbitrage. The “Risk” part of the name refers to the risk that a deal may not close causing traders to suffer significant losses. The “Arbitrage” is the practice of buying the target stock whilst simultaneously selling the acquirer stock (in the correct exchange ratio) so as to lock in a profit. However, the word risk is moot, as all investments and trading strategies come with some form of risk. In addition, arbitrage can take on a broad range of definitions across a spectrum of investment strategies. This concept is explored further in “Dynamic Hedging: Managing Vanilla and Exotic Options“ by Nassim Nicholas Taleb.
Risk arbitrage as a trading strategy has existed since the first half of the twentieth century. However, it was in the 1980’s following the dismantling of the conglomerates and the rise of junk bond financing that the strategy moved into the mainstream. By this time, Mergers and Acquisitions had become more refined with codified rules for operation. The burgeoning academic literature also added to the popularity of the strategy.
Therefore, as new trading strategies became popular and mainstream, a more focused description was required. This is where the term Merger Arbitrage came to the fore. Nowadays, the terms are used interchangedly although many traders still preferring one or the other. For more information on this event driven trading strategy, please see Merger Arbitrage or continue reading below for a brief example.
Risk Arbitrage Example
As an example, let’s use the AON (AON) and Willis Towers Watson (WLTW) merger announced on March 9, 2020. This is a stock swap deal where AON offered 1.08 of its own shares for each WLTW share. With the AON stock price at $165, the WLTW will receive a merger consideration of
$165.00 x 1.08 = $178.20
As the current stock price of WLTW is $167.21, there is a potential risk arbitrage profit of $178.20 – $167.21 = $10.99. This value is known as the spread, or merger arbitrage spread (Merger Arbitrage Limited also supplies an additional list of cash merger arbitrage spreads as part of our T20 Portfolio coverage). To lock-in the value of the spread, the trader buys the target stock and takes a short position in the acquirer stock. The risk in this investment is that the deal will not consummate. For this reason, the spread exists and can be used as a guide to the Deal Closing Probability (DCP). A larger spread implies a lower DCP. If this deal does not close, the target stock may drop in value causing a loss to the trader. Simultaneously, the acquirer stock may rise in value causing significant losses to the trader due to the shorting of the acquirer stock.
In our introductory article to trading this particular event driven investment strategy “How to Profit from Merger Arbitrage Trading” will explain how dividends and interest rates may affect this calculation. For traders who wish to pursue this kind of investment see our “Trading Merger Arbitrage with Interactive Brokers – A Practical Guide“.
