Risk Arbitrage
Categories: Trading
See: Arbitrage.
MegaFood Inc., a massive grocery story chain, agrees to purchase Greta's Garden Grocery, a local chain of produce boutiques in the Pacific Northwest. MegaFood is going to buy the company in stock-for-stock merger, trading its stock for shares of Greta's.
The deal calls for MegaFoods to exchange it's shares 1-to-2 for Greta's, so that Greta shareholders will receive 1 share of MegaFoods for every 2 shares they own of Greta's. At the time the merger is announced, MegaFoods is trading at $31 and Greta's is trading at $10...though it immediately jumps to $14 on the news.
Now, eventually, those prices will converge. As long as the deal closes, two shares of Greta's will be worth the same amount as a single share of MegaFoods. We know this...because that's the deal the companies struck. On the day the merger closes, each Greta shareholder can swap two of their shares for one share of MegaFoods. So if Greta's is trading at $14, then MegaFoods should be trading at $28. Or, if MegaFoods is trading at $31, then Greta's should be trading at $15.50. But they aren't. There's a bit of a mismatch. Room for some risk arbitrage.
There can be a couple reasons the shares don't jump directly into complete alignment. One is just market inefficiency. But the biggest cause has to do with uncertainty about the deal closing. The chances might be small, but there's still a possibility that something will scuttle the deal. Regulatory issues. Shareholders voting against the deal. Another bidder coming in. Lots of things can happen.
A risk arbitrager bets that those things won't happen. They bet that the deal will go through, and that the value of the stocks will come into alignment. As such, they will buy shares of the target company (Greta's in this case) and short shares of the acquiring company (MegaFoods here). Either Greta's will rise to match the proper price of the MegaFoods shares, or MegaFoods will fall to reach alignment of Greta's. Or...a little of both will happen.
Whatever the case, as long as the deal goes through, the risk arbitrager makes money.
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Finance: What is Arbitrage?22228 Views
finance a la shmoop what is arbitrage? not yourbritage or mybitrage but
arbitrage what it's been a while since we conjugated anything around here oh ok [Man talking about arbitrage]
so moving on arbitrage is a riskless trade you make guaranteed profits just
for being on top of things or in the right place at the right time or you're
there when opportunity comes a-knockin think about the stock exchanges in the [Men working in stock exchange]
pre-internet era around the world communication well it was relatively
slow and expensive back then especially when it came to sharing data one [Man talking into olden microphone]
relatively easy arbitrage or riskless trade opportunity that came about was
when stocks traded at one price on the various european exchanges versus the
prices it traded at on the US exchanges like shares of IBM might have been [Share price graph of IBM]
offered for sale at $165 32 cents on the london stock exchange even net of
currency conversion prices remember the Brits were on the pound system but in
the US investors were paying $165 47 cents a share
so an easy 15 cents a share was made all day long in buying the shares of IBM in
London and then just selling him back here in New York well both sides of the
trade were made at the same time it was riskless it was arbitrage and arbitrage
became a whole industry for a while until the capital markets went to work
and spreads tightened as communication got more liquid and people sprayed a [Spreads word becomes narrower]
bunch of wd-40 on information passing around the world and then that 15 cent [15 cents transfers from US to England]
spread from London to New York became more like a penny or a tenth of a penny
or at least close enough of a spread so that it was no longer worth bothering to
try and make a buck or a billion whatever those arbitrageours made in
those days