A:

Traders can implement a merger arbitrage trading strategy by buying the stock of the target company involved in the merger, while simultaneously selling the stock of the acquiring company involved in the merger.

Arbitrage Trading

All arbitrage trading strategies are based on profiting from temporary price discrepancies or market inefficiencies. Merger arbitrage trading strategies seek to profit from the temporary price discrepancies that typically occur when a merger or acquisition takes place.

When a potential acquirer initiates a merger, it commonly bids for the target company at a price higher than the target company's market price prior to the announced merger. This is the price the merged companies will have when the merger is closed.

The common reaction to a merger announcement is the target company's stock price rising while the acquiring company's stock price falls, with both approaching the merger bid price. However, due to the uncertainty of the deal being consummated, the target company's share price typically remains somewhat below the proposed acquisition price. The spread between the offer price and the target company's share price reflects the market's level of uncertainty regarding the deal going through.

Making the Spread

Whatever the spread is between the offer price and the target company's price at the time the arbitrage trade is made is the profit the arbitrage trader is seeking to lock in. For example, the acquiring company, with its stock trading at $110 per share, makes an offer for the target company, whose stock is trading at $90 per share, of $105 per share. As soon as the merger is proposed, both stock prices typically move toward the offer price. An arbitrager buys the target company's stock and sells short the acquiring company's stock, seeking to profit from a continued narrowing of the spread between the two prices. The trade can be unwound at any point the trader has a net profit between his buy and short-sell trades. If he holds the trade till the merger is complete, he can deliver his target company shares, now converted to acquirer shares, to satisfy his short sale.

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