Chendi Zhang

Warwick Business School

Lecture outline

definition and workings

recent empirical evidence on arbitrage spreads and returns to

merger arbitrage hedge funds
Jetley and Ji (FAJ 2010)

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Definition

merger arbitrage is a form of speculation on the outcome of

takeover bids
takes place after the deal announcement
if before the deal announcement problem with private information as

trading on private information is illegal

playing on the probability of a deal completing
sometime also referred to a risk arbitrage (a broader term)

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Definition

it takes advantage of the arbitrage spread

arbitrage spread is the difference between the acquisition price and the

price at which the targets stock trades before the consummation of the
merger
the arbitrage spread is realized over the period between the mergers
announcement and its consummation (105 days, time value of money)
a discount on the offer price due to probability of the deal going through
is smaller than one
so, merger arbitrage bears the risk that the deal might not be
successfully completed merger arbitrage is a risky strategy (so it is
not really an arbitrage)
but still, merger arbitrage seems to be associated with large excess
returns (a frequent hedge fund strategy)

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Example

on 10 July 2008, the Dow Chemical Company announced the

acquisition of Rohm and Haas Company (ROH) for $78.00 a
share in cash

in response to the announcement, ROHs stock price increased

by more than 60% to close at $73.62

the arbitrage spread at the close of the NYSE on 10 July 2008

was $4.38, or 5.9% ($4.38 as a percentage of $73.62)

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Target returns for a successful deal

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Target returns for an unsuccessful deal

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Trading strategy

depends on the payment consideration

in all-cash offers, the arbitrageur goes long on the target stock

and gets money for his shares when the deal is completed
,

arbitrage spread is then

in all-stock offers, the strategy has to take into account that

target shareholders are paid by the acquiring firm stock

so if an arbitrageur only went long on the target shares, he would be

exposed to price movements of the acquiring firm stock

to avoid this, he shorts acquiring firms stock in exact proportion to the
stock payment consideration (exchange ratio )

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Trading strategy

shorting the acquiring firm stock is straightforward in fixed

exchange ratio stock offers when a fixed exchange ratio is
announced together with the deal
one shorts the acquiring firm stock in proportion to the exchange ratio
example: if I get acquiring firm shares for each share of the target, I

have to short , where is the number of target firm shares I

bought

the arbitrage spread is then

, ,
,

in floating exchange ratio deals, the risk is eliminated only

once the exchange ratio is set during the pricing period
pricing period is usually later in the process
one shorts only once the exchange ratio is set

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Successful trading strategy

several studies have reported large excess returns related to

the merger arbitrage investment strategy
Larcker and Lys (1987), Mitchell and Pulvino (2001), Baker and Savasoglu

(2002), and Jindra and Walkling (2004)

several reasons have been suggested for the excess returns

excess return represents compensation for acquiring costly private

information
arbitrageurs risk running out of capital when the best opportunities
exist, and thus, they become more cautious when they make their initial
trades; this action, in turn, limits their ability to price away any
inefficiencies
excess returns represent compensation for providing liquidity, especially
in down markets
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Merger arbitrage hedge funds

popularity of merger arbitrage as an investment strategy has

grown over the years

the assets under management of merger arbitrage hedge funds

grew from $233 million at the end of 1990 to $28 billion by the
end of 2007 (Hedge Fund Research 2008)

event-driven arbitrage funds were able to generate positive

alphas of about 1% a month (Agarwal and Naik, 2000)

risk arbitrage generates riskreturn profiles that are superior to

those of other hedge fund strategies (Ackermann et al., 1999)

recently, studies have documented the general decline in

merger arbitrage hedge fund alphas (Fung et al, 2008)

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Evolution of arbitrage spread

Jetley and Ji (FAJ 2010), data over 1990-2007, US companies

completed and failed

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Evolution of arbitrage spreads

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Median arbitrage spread, successful deals

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Returns of merger arbitrage hedge funds

monthly return data from the HFRI Merger Arbitrage Index

the medians of monthly returns are 96 bps over 1990-95, 99 bps over
1996-01, and 51 bps over 2002-07

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Reasons for the decline in the arbitrage spread

transaction costs
direct cost declining since 1990 (from 64bsp to 11bsp between 1990

2006)
indirect cost price impact of trades, declined as well due to increased
liquidity
compare arbitrage spreads of successful deals on the day completion
was announced (risk is zero and time value of money is negligible)
62 bps over 1990-95, 62 bps over 1996-01, and 6 bps over 2002-07 (for
cash deals)
107 bps over 1990-95, 82 bps over 1996-01, and 51 bps over 2002-07
(for stock deals)

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Reasons for the decline in the arbitrage spread

capacity constraints (more money chasing a limited number of

deals)
between 1990 and 2007, net inflows into merger arbitrage hedge funds

were equal to $18.3 billion, of which $14.8 billion was attributable to

net inflows since 2000 (HFR, 2008)
check trading volume in the target stock subsequent to the merger
announcement (relative to normal level of volume)
industry insiders have estimated that, on average, arbitrage funds own
as much as 50% of the target

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Relative volume

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Relative volume, successful deals

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Reasons for the decline in the arbitrage spread

reduction in risks associated with risk arbitrage

completion risk compare success rates over time it remained

relatively stable though

uncertainty about the loss in the event of failure
check the bid premium the average bid premium declined from 45% for

1996-01 to 36% for 2002-07 and the difference between the means is
statistically significant
also, the probability that targets in failed transactions may be involved in
subsequent transactions increased over 2002-07, such that the targets stock
prices did not revert to pre-merger levels
other risk factors concern deal terms and time to consummate

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Summary

what is merger arbitrage?

definition, strategies, risks

development of arbitrage spreads excess return on merger

arbitrage hedge funds since 1990s
they declined and are likely to remain relatively low

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References
Jetley and Ji, 2010, The shrinking merger arbitrage spread: Reasons and implications, Finanicial
Analyst Journal 66 (2), 5468.
Larcker and Lys, 1987, An empirical analysis of the incentives to engage in costly information
acquisition: The case of risk arbitrage, Journal of Financial Economics 18, 111126.
Mitchell and Pulvino, 2001, Characteristics of risk and return in risk arbitrage, Journal of Finance
56, 21352175.
Baker and Savasoglu, 2002, Limited arbitrage in mergers and acquisitions, Journal of Financial
Economics 64, 91115.

Jindra and Walkling, 2004, Speculation spreads and the market pricing of proposed acquisitions,
Journal of Corporate Finance 10, 495526.
Agarwal and Naik, 2000, On taking the Alternative Route: Risks, rewards, and performance
persistence of hedge funds, Journal of Alternative Investments 2(4), 623.

Ackermann, McEnally, and Ravenscraft, 1999, The performance of hedge funds: Risk, return, and
incentives. Journal of Finance 54, 833874.
Fung, Hsieh, Naik, and Ramadorai, 2008, Hedge Funds: Performance, risk and capital formation,
Journal of Finance 63, 17771803.
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