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Risk arbitrage strategy suggests that upon the announcement of M&A the target company’s stock typically trades at a discount to the price offered by the acquiring company. The arbitrageur is trying to profit from this spread. If the merger is successful, the arbitrageur captures the arbitrage spread. However, if the merger fails, the arbitrageur incurs a loss.

There are two basic types of mergers, cash mergers and stock mergers. In a cash merger, the acquiring company offers to exchange cash for the target company’s equity or assets. In a stock merger, the acquirer offers its common stock instead of cash.

The arbitrageur ’s strategy depends on the form of merger. In cash merger, simply buys the target company’s stock. As the target’s stock usually sells at a discount to the payment promised by the acquirer, profits can be made by buying the target’s stock and holding till merger end and selling the target’s common stock to the acquiring firm for the offer price. This strategy assumes two sources of profit: the main comes from the difference between the purchase price of the target’s stock and the ultimate offer price, the second is the dividend paid by the target company.

In a stock merger, the arbitrageur sells short the acquiring firm’s stock and buys the target’s stock (at the same time). This strategy provides three sources of the arbitrageur ’s profit. The main source of prof it is the difference between the short position in acquirer ’s stock and long in the target’s stock. The second source of profit is the dividend paid on the target’s stock (though this is offset by dividends that must be paid on the acquirer ’s stock, since it was borrowed and sold short). The third source of prof its in a stock deal comes from interest paid by the arbitrageur ’s to broker for the short position.

The main risk of all of this strategy is that returns...
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