Risk Arbitrage 101

Risk arbitrage (also called merger arbitrage) is where an investor buys stock in a company that’s expecting to be taken over. The investor’s goal is to profit from the difference in current market price and eventual buyout price. Here’s a simple example: Company A announces that it will acquire Company B for $20 per share. Immediately after the announcement, the share price moves from $15 to $19 per share. The arbitrageur then purchases the stock, hoping to make a $1 profit once the deal is complete.

Why doesn’t Company B just move straight to $20 after the announcement? Why the $1 difference? There are a number of reasons. 

First, since the merger usually takes some time to complete, part of the $1 represents the “time value” of not receiving the $20 right away. 

But most of the discrepancy usually represents the market’s uncertainty about the final outcome. The deal may fall through for multiple reasons, such as financing problems, regulatory roadblocks, or the acquirer simply changing their mind. 

So the risk arbitrageur has two questions to answer: will the deal go through – and if so, how long will it take?

Merger arbitrage is like a simpler, time-constrained version of value investing. When screening for candidates, there’s no need to do valuation work because the value of the company has already been announced. Both arbitrage and value investing involve handicapping the odds and buying assets for less than they are worth. With that in mind, below are some important things to consider when making any arbitrage investment.