Arbitrage is a term that gets thrown around a lot on Wall Street. In its purest form, arbitrage takes advantage of the discrepancy in price between identical or nearly-identical securities on different markets. For example, if a stock is trading at $100-$100.01 on one exchange and $100.02-$100.03 on another exchange, then an arbitrageur could take the asking price and buy the stock for $100.01 on the first exchange and take the bid and sell the same stock for $100.02 on the second exchange,making a risk-free $0.01/share profit.

However, these types of arbitrage opportunities rarely last longer thana blink of the eye. As a result, investors seek out relative value trades that are sometimes also called arbitrage trades. In this post, well take a look at the merger arbitrage strategy.

Generally, when one company decides to purchase another company, the two sides negotiate behind the scenes and come to an agreement on a sale price. The deal is then announced to the public, and the market moves on the reported transaction. However, even though the two sides agree to a sale, that doesnt mean the deal always gets completed. There are a number of legal, regulatory, and financial hurdles that can lead to a deal falling apart.

In a merger arbitrage trade, investors bet on the likelihood that a deal will be completed. For example, lets say that Company A wants to buy Company B. Before the deal, Company A is worth $20/share and Company B is worth $10/share. Company A agrees to buy Company B for $20/share. Once the deal is announced, Company A usually will trade roughly unchanged (more commonly it is slightly down on the deal announcement), and Company B spikes higher. However, Company B doesnt immediately start trading at $20, the agreed-upon purchase price. It might trade for something like $18/share.

An investor wanting to execute a merger arbitrage trade might choose to purchase Company B for $18/share. They hope that the deal goes through, when they would receive $20/share from Company A for their shares, making a $2/share profit. Of course, if the deal falls apart, Company Bs shares may fall to $10/share, leading to an $8 loss. However, if you strongly believe that the deal will get completed, then you will buy the shares.

Of course, a strategy of blindly buying any merger that occurs, waiting for the merger to get completed, is a recipe for disaster. The market knows that not all mergers are completed, which is why it does not price the company being acquired at the agreed-upon purchase price. The discount it is placing on the companys stock reflects the markets assessment of whether or not the deal goes through. As trading continues after the deal announcement, buyers and sellers converge on a price based on the probability of the deal occurring. As additional information becomes available, the price will move towards or away from the purchase price.

The skill in merger arbitrage is in assessing the likelihood of a deal being completed better than the stock market. This requires expertise in the legal, accounting, and regulatory intricacies of merger and acquisition deals. Its unlikely that an individual investor will be able to match professional investors in understanding these deals, who might employ lawyers and financial analysts to help them.

In certain cases, hedge funds will even try to influence the outcome of a deal. Some hedge funds havemounted legal challengesarguing that a deal price should be higher than the agreed-upon deal price. Similar to how an appraisal may cause the final sale price of a home to be different than the initially agreed-upon price between the buyer and seller, courts have ruled in some cases that companies be sold at higher than the announced deal price. Hedge funds that have bought the company being acquired profit in this scenario. However,there have been court rulingsthat suggest that this strategy may not continue to work in the future.

There is always the possibility of insider trading or trading based on rumors when dealing with these types of transactions. The market price of the companies in a deal will move up and down in the weeks and months following the merger announcement based on new information. Some of this new information may leak into the market in the form of rumors.

It is also possible that some investors may have insider information about a deal and profit using their information advantage. Of course, insider trading is illegal, and traders who have traded on insider information have beenprosecuted and served jail time for their actions.

There are several ways to measure merger arbitrage performance. One way to assess the performance of this strategy is to look at the index form of a merger arbitrage strategy. TheS&P Merger Arbitrage Indexis a long-short index for companies in pending mergers. While being a market-neutral strategy with relatively low correlation with the S&P 500, it nevertheless has underperformed the S&P 500 over the period of 2008-2018.

An alternative merger arbitrage strategy is to only purchase the companies that are being purchased, i.e. a long-only merger arbitrage strategy. TheS&P Long-Only Merger Arbitrage Indextracks this strategy, and has done significantly better than the S&P Merger Arbitrage Index, although some of its perfomance may be related with the general rise in the stock market, independent of the probabilities that merger deals actually get done.

The final way is to look at the merger arbitrage strategy is to evaluate the performance of hedge funds that are using these strategies. TheEureka Hedge Fund Arbitrage Indextracks merger arbitrage strategies, and it has outperformed the morepassive approach to merger arbitrageseen in the S&P indices.

Merger arbitrage is not really arbitrage, but a relative value trade. It attempts to profit on the discrepancy between the current stock price and the anticipated acquisition price of a company being acquired after a deal is announced. The efficient market hypothesis suggests that the market correctly prices the probability that a deal will be completed, making it difficult to beat the market with a merger arbitrage strategy.

Individuals or investment funds that seek to make money on merger deals need to better understand the legal and regulatory implications of each deal than the general market. This requires extensive time and effort unavailable to clinical physicians or retail investors. It is unclear whether hedge funds or mutual funds that specialize in merger arbitrage will be able to add enough value to overcome their management fees.

What do you think? Do you invest in merger arbitrage deals? Do you think with enough time, effort, and expertise, an investment fund can beat the market with merger arbitrage deals?

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I would run for the hills if someone asked me to invest in one of these. Our portfolio is boring. Today is the first time Ive heard of this trype of trade.

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Before I went to medical school, I worked on Wall Street as a trader at an investment bank. Now I am a physician helping fellow doctors navigate the crazy world of finance.

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