Risk arbitrage

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Risk arbitrage, or merger arbitrage, is an investment or trading strategy often associated with hedge funds.

Two principal types of arbitrage are possible:

In a cash merger, an acquirer proposes to purchase the shares of the target for a certain price in cash. Before the acquisition is completed, the stock of the target trades below the purchase price. An arbitrageur buys the stock of the target and makes a gain if the acquirer ultimately buys the stock.

In a stock for stock merger, the acquirer proposes to buy the target by exchanging its own stock for the stock of the target. An arbitrageur will then short sell the acquirer and buy the stock of the target. After the merger is completed, the target's stock will be converted into stock of the acquirer based on the exchange ratio determined by the merger agreement. The arbitrageur delivers the converted stock into her short position to complete the arbitrage.

If that were all there was to it, then everyone would do it immediately, and any possible gain would disappear very quickly. But there is more to it, the risk that the deal won't go through or the closing will be materially delayed, because of either party's inability to satisfy certain closing conditions such as failure to obtain the requisite shareholder approval, failure to receive antitrust and other regulatory clearances, or occurrence of a "material adverse effect" (which may change the target's or the acquirer's willingness to consummate the transaction). Such possibilities put the risk in the term risk arbitrage.

Additional complications can arise in stock for stock mergers when the exchange ratio is not constant but changes with the price of the acquirer. These are called "collars" and arbitrageurs use options-based models to value deals with collars. In addition, the exchange ratio is commonly determined by taking the average of the acquirer's closing price over a period of time (typically 10 trading days prior to close), during which time the arbitrageur would actively hedge his position in order to ensure the correct hedge ratio.

When hedge fund strategies are sorted into categories, risk arbitrage is sometimes included with other forms of arbitrage such as relative value, volatility arb, convertible arb, and stat arb. But it can also be included as one among the event driven strategies.