What is Arbitrage?
Arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices.
Example: In the 19th century, the Rothschilds would buy gold in London one day and sell it the next day in Paris, arbitraging any differences in price between the two markets.
Now, What is Merger Arbitrage?
Merger arbitrage uses arbitrage strategies to profit from changes in stock price related to a corporate merger or acquisition.
Example: Company XYZ announces it is going to purchase company ABC for $30 dollars a share in four months, and ABC’s stock price is currently trading at $20 a share. ABC’s stock price won’t immediately move to the takeover price. Because there are risks the deal won’t go through or may take longer than announced, ABC stock may only move to $29 dollars a share. The 1 dollar difference, or the “spread”, represents the risk that the deal won’t go through. This spread is the focus of arbitrage strategies. To perform arbitrage an investor would purchase ABC at $29 and simultaneously short the acquiring company in order to capture this spread, betting the deal will go through and prices will eventually converge at $30.
Benefits and Risks
In theory, merger arbitrage should be considered risk-less, since it exploits a clear price inefficiency. In reality there is always the risk that the merger being arbitraged will not close or may take longer than planned. This risk can be diversified away to some degree by investing in up to 50 or 60 deals simultaneously. Additional risks associated with merger arbitrage include turnover and options risks, which can decrease performance and increase costs.
Investments in these strategies can result in steady, market neutral returns, typically twice that of the 90 day T-Bill. Allocations to this strategy, which has low correlations to the overall stock and bond market, can lower the overall volatility of a portfolio and increase diversification.
The information in this post was compiled by S. Zachary Fineberg, Lead Portfolio Manager at Fineberg Wealth Management, LLC, a registered investment advisory firm located in Ann Arbor, MI. If you would like to discuss how utilizing arbitrage strategies may add diversification to your portfolio, please contact us by email or call (734) 230-7900.