Risk arbitrage an investment strategy to profit from the narrowing of a gap of the trading price of a target's stock and the acquirer's valuation of that stock in an intended takeover deal. In a stock-for-stock merger, risk arbitrage involves buying the shares of the target and selling short the shares of the acquirer. This investment strategy will be profitable if the deal is consummated; if it is not, the investor will lose money.

Breaking Down Risk Arbitrage

When an M&A deal is announced, the target firm's stock price jumps toward the valuation set by the acquirer. The acquirer will propose to finance the transaction in one of three ways: all cash, all stock or a combination of cash and stock. In the case of all cash, the target's stock price will trade near or at the acquirer's valuation price. In some instances, the target's stock price will surpass the offer price because the market may believe that the target is put in play to a higher bidder, or the market may believe that the cash offer price is too low for the shareholders and Board of Directors of the target company to accept.

In most cases, however, there is a spread between the trading price of the target just after the deal announcement and the buyer's offer price. This spread will develop if the market thinks that the deal will not close at the offer price or may not close at all. Purists do not think this is risk arbitrage because the investor is simply going long the target stock with the hope or expectation that it will rise toward or meet the all-cash offer price. Those with an expanded definition of "arbitrage" would point out that the investor is attempting to take advantage of a short-term price discrepancy.

In an all-stock offer, whereby a fixed ratio of the acquirer's shares are offered in exchange for outstanding shares of the target, there is no doubt that risk arbitrage would be at work. When a company announces its intent to acquire another company, the acquirer's stock price typically declines, while the target company's stock price generally rises. However, the target company's stock price often remains below the announced acquisition valuation. In an all-stock offer, a "risk arb" (as such an investor is known colloquially) buys shares of the target company and simultaneously short sells shares of the acquirer. If the deal is completed, and the target company's stock is converted into the acquiring company's stock, the risk arb can use the converted stock to cover his short position. The risk arb's play becomes slightly more complicated for a deal that involves cash and stock, but the mechanics are largely the same.

Main Risk to the Strategy

The investor is exposed to the major risk that the deal is called off or rejected by regulators. If the deal does not happen for whatever reason, the usual result would be a drop - potentially sharp - in the stock price of the target and a rise in the stock price of the would-be acquirer. An investor who is long the target's shares and short the acquirer's shares will suffer losses.