Merger arbitrage
Also known as: merger arb, risk arbitrage
Merger arbitrage is a strategy that trades the gap between a target company's price and the price an acquirer has agreed to pay for it once a merger is announced. After a deal is announced, the target's typically jumps toward the offer price but usually still trades at a modest discount to it, reflecting the market's assessment of the risk that the deal might not close.
A merger arbitrage investor buys the target's at that discount and profits by capturing the spread if the deal closes as announced. In a cash deal this is straightforward, buy the target and wait. In a -for- deal, the investor typically also shorts the acquirer's in the ratio specified by the deal terms, isolating the spread itself rather than taking a view on either company's price.
The main risk is that the deal falls apart, due to regulatory objections, financing problems, a competing bid, or the target's voting it down, in which case the target's usually falls back toward where it traded before the deal was announced, often well below the arbitrage entry price. Because of this binary risk, merger arbitrage returns tend to look like a steady stream of small gains punctuated by occasional larger losses when a deal breaks.