Abbot - Alza Case

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Risk arbitrage (or merge arbitrage) is a trading strategy related to M&A transactions. For example, if an M&A transaction is carried out by means of share exchange between the buzzer and the target, then an arbitrageur may short sell buyer’s stocks and purchase stocks of the target. Until the acquisition is completed, the stock of the target typically trades below the purchase price. After the merger is completed, the target's stock will be converted into stock of the acquirer based on the exchange ratio predetermined in the merger agreement. The arbitrageur delivers the converted stock into his short position to complete the arbitrage. In an efficient capital market, the price of the target and acquirer will fully and immediately reflect the terms of the merger. However, risk arises from the possibility of deals failing to go through. Such possibility put the risk in the term “risk arbitrage”. Green circle had USD 500 million in AUM with 5% upper bound of position in a distinct investment (or 25 million). Smith arbitrage position was within the bounds or 13.5 million in short Abbot and 12.5 million in long position for Alza stocks. The proportion between Abbot and Alza shares was determined by the appropriate market prices of Abbot and Alza shares and announced exchange ratio of 1.2 Abbot sahres per 1 Alza share under the merger deal agreement. The potential return on investment could be up to 10% (or 19% annualized). Such high potential return on the investment is balance by the risk of deal break. For calculations please refer to Excel file sheet Q2. At the same time the expected return is a probability-weighted potential returns for different scenarios, e.g. either merge will be processed or not. Also it should be noted that expected return may change in time, i.e. probability of merge was high in June 1999, but this probability approached almost zero in October-November 1999. First excess return it’s return above the treasury security. In this case...
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