What is 'Merger Arbitrage'

Merger arbitrage involves simultaneously purchasing and selling the stocks of two merging companies to create "riskless" profits and is often considered a hedge fund strategy. A merger arbitrageur looks at the risk the merger deal will not close on time, or at all. Because of this slight uncertainty, the target company's stock typically sells at a discount to the price of the combined company when the merger is closed; this discrepancy is the arbitrageur's profit.

BREAKING DOWN 'Merger Arbitrage'

Merger arbitrage is a subset of event-driven investing or trading, which involves exploiting market inefficiencies before or after a merger or acquisition. A regular portfolio manager may focus only on the profitability of the merged entity. In contrast, merger arbitrageurs care only about the probability of the deal being approved and how long it will take the deal to close. Since there is a probability the deal may not be approved, merger arbitrage is a form of risk arbitrage and carries a relatively low degree of risk.

Merger Arbitrage Mechanics

There are two main types of corporate mergers: cash and stock mergers. In a cash merger, the acquiring company purchases the target company's shares for cash, while a stock-for-stock merger involves the exchange of the acquiring company's stock for the target company's stock. When a corporation announces its intent to acquire another corporation, the acquiring company's stock price typically declines, while the target company's stock price generally rises. However, the target company's stock price typically remains below the announced acquisition price. This discount reflects the uncertainty of the deal. In an all-cash merger, investors generally take a long position in the target firm.

In a stock-for-stock merger, a merger arbitrageur typically buys shares of the target company's stock while shorting shares of the acquiring company's stock. Therefore, if the deal is completed, and the target company’s stock is converted into the acquiring company’s stock, the merger arbitrageur could simply use the converted stock to cover the short position. A merger arbitrageur could also replicate this strategy using options, such as purchasing shares of the target company's stock while purchasing put options on the acquiring company's stock.

If a merger arbitrageur expects a merger deal to break, the arbitrageur may short shares of the target company's stock. If a merger deal breaks, the target company's share price typically falls to its share price prior to the announcement of the deal. Mergers may break due to a multitude of reasons, such as regulations, financial instability or unfavorable tax implications.

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