Editing Risk arbitrage (section)

== Basics ==

=== Mergers ===
In a [[merger]], one company, the acquirer, makes an offer to purchase the shares of another company, the target. As compensation, the target will receive cash at a specified price, the acquirer's stock at specified ratio, or a combination of the two.

In a [[mergers and acquisitions#Cash|cash merger]], the acquirer offers to purchase the shares of the target for a certain price in cash. The target's stock price will most likely increase when the acquirer makes the offer, but the stock price will remain below the offer value.<ref name=barclayhedge /> In some cases, the target's stock price will increase to a level above the offer price. This would indicate that investors expect that a higher bid could be coming for the target, either from the acquirer or from a third party.<ref name="demeter">{{cite web|last1=Demeter|first1=Michael|title=Merger (Risk) Arbitrage Strategy|url=http://www.aima.org/filemanager/root/site_assets/canada/publications/strategy_paper_-_merger_arbitrage.pdf}}</ref> To initiate a position, the arbitrageur will buy the target's stock. The arbitrageur makes a profit when the target's stock price approaches the offer price, which will occur when the likelihood of deal consummation increases. The target's stock price will be equal to the offer price upon deal completion.

In a [[mergers and acquisitions#Stock|stock merger]], the acquirer offers to purchase the target by exchanging its own stock for the target's stock at a specified ratio. To initiate a position, the arbitrageur will buy the target's stock and [[Short selling|short sell]] the acquirer's stock.<ref name=barclayhedge /> This process is called "setting a spread". The size of the spread positively correlates to the perceived risk that the deal will not be consummated at its original terms.<ref name=demeter /> The arbitrageur makes a profit when the spread narrows, which occurs when deal consummation appears more likely. Upon deal completion, the target's stock will be converted into stock of the acquirer based on the exchange ratio determined by the merger agreement. At this point in time, the spread will close. The arbitrageur delivers the converted stock into his short position to close his position.

=== Predictors of merger success ===
Baker and Savasoglu contend that the best single predictor of merger success is hostility: only 38% of [[Takeover#Hostile Takeovers|hostile]] deals were successfully consummated, while so-called [[Takeover#Friendly takeovers|friendly]] deals boasted a success rate of 82%.<ref name=baker/> [[Francesca Cornelli|Cornelli]] and Li contend that arbitrageurs are actually the most important element in determining the success of a merger. Since arbitrageurs have made significant financial bets that the merger will go through, it is expected that they will push for consummation. For this very reason, the probability that the merger will consummate increases as arbitrageur control increases.<ref name="cornelli">{{cite web|last1=Cornelli|first1=Francesca|author1-link=Francesca Cornelli|last2=Li|first2=David|title=Risk Arbitrage in Takeovers|url=http://rfs.oxfordjournals.org/content/15/3/837.full.pdf+html}}{{dead link|date=May 2021|bot=medic}}{{cbignore|bot=medic}}</ref> In their study, Cornelli and Li found that the arbitrage industry would hold as much as 30%-40% of a target's stock during the merger process. This represents a significant portion of the shares required to vote yes to deal consummation in most mergers. Thus, takeovers in which arbitrageurs bought shares had an actual success rate higher than the average probability of success implied by market prices.<ref name=cornelli/> As a result, they can generate substantial positive returns on their portfolio positions.

=== Active vs. passive risk arbitrage===
The arbitrageur can generate returns either actively or passively. Active arbitrageurs purchase enough stock in the target to control the outcome of the merger. These [[Activist shareholder|activist investors]] initiate sales processes or hold back support from ongoing mergers in attempts to solicit a higher bid. On the other end of the spectrum, passive arbitrageurs do not influence the outcome of the merger.<ref name="hsieh">{{cite web|last1=Hsieh|first1=Jim|last2=Walkling|first2=Ralph|title=Determinants and implications of arbitrage holdings in acquisitions|url=http://mason.gmu.edu/~jhsieh/files/Hsieh%20Walkling%202005%20JFE.pdf}}</ref> One set of passive arbitrageurs invests in deals that the market expects to succeed and increases holdings if the probability of success improves.<ref name=hsieh/> The other set of passive arbitrageurs is more involved, but passive nonetheless: these arbitrageurs are more selective with their investments, meticulously testing assumptions on the risk-reward profile of individual deals. This set of arbitrageurs will invest in deals in which they conclude that the probability of success is greater than what the spread implies.<ref name=hsieh/> Passive arbitrageurs have more freedom in very liquid stocks: the more liquid the target stock, the better risk arbitrageurs can hide their trade.<ref name=cornelli/> In this case, using the assumption that a higher arbitrageur presence increases the probability of consummation, the share price will not fully reflect the increased probability of success and the risk arbitrageur can buy shares and make a profit.<ref name=cornelli/> The arbitrageur must decide whether an active role or a passive role in the merger is the more attractive option in a given situation.