Risk Arbitrage Case

Topics: Stock, Arbitrage, Long Pages: 5 (1453 words) Published: November 1, 2012
Risk Arbitrage: Abbott Labs and Alza
Harvard Business Review Case Study

Risk Arbitrage is essentially just arbitrage with some element of risk. Three main types of risk arbitrage are merger and acquisition arbitrage (also known as just merger arbitrage), liquidation arbitrage, and pairs trading. We will focus on merger arbitrage, as it pertains to this case study. Merger arbitrage is an investment strategy that chooses to capitalize upon arbitrage that presents when a merger or acquisition deal is announced. Essentially, an arbitrageur is seeking to profit from the movements of the acquirer’s and or target’s stock price from the merger. There are two main types of mergers, a cash merger and a stock merger, which determines how the arbitrage positions the investment. A major inherent risk of risk arbitrage is the risk that the deal will not be completed and that the position will suffer significant loss.

There are two principal types of mergers, both of which an arbitrageur can take advantage. First, is a cash merger, in which the acquirer proposes to purchase the target firm for a certain price in cash. Typically, the price of the target will trade below the proposed price, so the arbitrageur can buy a long position in the target firm; when the firm is acquired, the stock price will increase and the arbitrageur will profit. The second type of merger is a stock for stock merger, which is the merger being studied in this case. In a stock for stock merger, the acquiring firm proposes to trade its own stock for the stock of the target firm. A typical position in this case is a long-short position in which the arbitrageur places a long position in the target firm and a short position in the acquiring firm; this is known as “setting a spread.” If the merger is completed, the target stock will be converted into the acquirer’s stock based on the exchange ratio that was determined by the merger agreement. The arbitrageur then delivers the converted target firm stock into his short position to complete the arbitrage. Essentially, the arbitrageur is aiming to capitalize in the difference of the prices of the two firms’ stocks, which will essentially converge somewhere in the middle once the deal is completed. Market Efficiency does not prevent these profits from persisting because the market is already accounting for the risk in a merger. If there was no risk in the merger, the before and after prices of the securities would be the same before and after the merger, and there would be no profits to be realized.

A major inherent risk is the risk that the deal will not be completed. Obstacles for a merger can include either party’s inability to satisfy all of the conditions of the merger, failure to receive antitrust and/or other regulatory clearances, and failure to obtain the shareholders’ approval (though this is sometimes not necessary). Other obstacles could be lawsuits against the merger, the inability of the acquiring firm to raise enough capital to make the purchase, or a decline in the value of the deal, such as when the acquiring firm’s stock price declines in a stock for stock merger. All of these factors are considered when making a position in a merger deal.

Chris Smith, founding partner of Green Circle Capital LP, is trying to decide about his current long position in Alza and short position in Abott Labs with consideration to their pending merger. Considering that it is already October 27th, 1999 and troubling news has emerged regarding the acquisition of Alza by Abbott Labs, Chris is unsure whether he should close the position and realize losses, hedge his position with options, or increase his position since the spread increased from $4.20 to $5.175. His Current position is a long position of 260,000 Alza shares purchases at $48, and a short position of 312,000 Abbott Labs shares that were sold at $43.50. Details of the position are found on the next page in Figure...
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