The reason for this is that there is no guarantee that the merger will be completed. The difference between the offer price and the target’s stock price is the arbitrage spread that risk arbitrageurs try to capture. If the merger is successful, the arbitrageur receives the arbitrage spread. If the merger fails, the arbitrageur incurs a loss.
There are two types of mergers: cash and stock. In a cash merger, the acquiring company offers to purchase the shares of the target company for a certain amount of cash. Afterward, the target’s stocks trade at a discount to the offer price.
In this situation, the risk arbitrageur buys stocks of the target. He gains if the merger is successful and the acquirer buys the stocks. In a stock merger, the acquirer announces a plan to exchange stocks of the target company in own stocks in a certain exchange ratio.
In this situation, the risk arbitrageur buys stocks of the target company and might go short in stocks of the acquiring company. If the merger is successfully completed, the target’s stock are converted into the acquirer’s stocks based on the given exchange ratio and the hedge fund manager again captures the arbitrage spread.
As it is necessary to build up a long position in the target company and (in case of a stock merger) maybe also a short position in the acquiring company, the liquidity of the stocks involved in merger and acquisition is of great importance for a successful risk arbitrage.
In addition, analysis of the legal situation is necessary, because the approval of the responsible regulator is one of the main impediments to many merger and acquisition transactions.
Risk arbitrage is a typical example of an event-driven strategy. It contains elements of many other hedge fund investment strategies, such as relative value, convertible arbitrage, volatility arbitrage, and statistical arbitrage.
Some authors also consider other trading opportunities in the company’s life cycle as forms of risk arbitrage. To these situations belong stock index reconstructions or stock repurchases, which might offer interesting arbitrage opportunities.