What is 'Risk Arbitrage'

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 a few cases, 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.

RELATED TERMS
  1. Forex Arbitrage

    Forex arbitrage is the simultaneous purchase and sale of currency ...
  2. Index Arbitrage

    Index arbitrage is a trading strategy that attempts to profit ...
  3. Statistical Arbitrage

    Statistical arbitrage is a profit situation arising from pricing ...
  4. Conversion Arbitrage

    Conversion arbitrage is an options trading strategy employed ...
  5. Swap Ratio

    Swap ratio is the ratio at which an acquiring company will offer ...
  6. Merger Securities

    Merger securities are non-cash assets paid to a company's shareholders ...
Related Articles
  1. Small Business

    How To Profit From Mergers And Acquisitions Through Arbitrage

    Making a windfall from a stock that attracts a takeover bid is an alluring proposition. But be warned – benefiting from m&a is easier said than done.
  2. Investing

    What Exactly Are Arbitrage Mutual Funds?

    Learn about arbitrage funds and how this type of investment generates profits by taking advantage of price differentials between the cash and futures markets.
  3. Investing

    How Precious Metals Like Gold Can Be Arbitraged

    Arbitrage trading involves a lot of risk and can get challenging. Find out how to benefit from the price differential between the buy and sell price.
  4. Investing

    How Statistical Arbitrage Can Lead to Big Profits

    Statistical arbitrage is one of the most influential trading strategies ever devised. Learn how it is leveraged by investors and traders seeking profits.
  5. Investing

    How To Profit From M&A Announcements

    We look at four strategies that seek to profit from merger and acquisitions announcements.
  6. Investing

    3 Mutual Funds Focusing on Arbitrage Profits (MERFX, ARBFX)

    Get details on three of the most popular mutual funds for investors interested in arbitrage trading.
  7. Investing

    How ETF Arbitrage Works

    ETF arbitrage brings the market price of ETFs back in line with net asset values when divergence happens. Learn how it works.
  8. Investing

    Hedge Funds Hunt for Upside, Regardless of Market

    Hedge funds seek positive absolute returns through aggressive strategies to make this happen.
RELATED FAQS
  1. How do I use the news to find arbitrage opportunities?

    Learn what risk arbitrage trading is and how this type of opportunity is available to individual retail investors. Read Answer >>
  2. How company stocks move during an acquisition

    During an acquisition, there's a short-term impact on the stock prices of both companies. Typically, the target company's ... Read Answer >>
  3. Why Isn't My Stock Trading at the Buyout Price?

    An acquisition or merger does not necessarily mean the deal will be resolved as originally stated. Read Answer >>
Trading Center