What Does Risk Arbitrage Mean?
Risk arbitrage is a strategy used to take advantage of the spread between the price at which a company trades at the time of the announcement of a proposal for merger or acquisition and the price when the transaction is closed at a future date. The gain depends on the probability that the deal will be closed and the length of time required to close the deal.
Risk arbitrage is also known as merger arbitrage.
Divestopedia Explains Risk Arbitrage
Risk arbitrage is based on the relative price difference between the stock of companies involved in mergers, divestitures, restructuring, etc. In this strategy, the stocks of the two companies involved in the merger and acquisition are simultaneously bought and sold to generate profits. The investor purchases the stock of the target firm, which then gets converted into the acquirer’s stock on completion of the deal, or is purchased by the acquirer at a price that's higher than the current market price.
In cash deals, the acquiring company offers a price higher than the current market price for the target company. In stock deals, the investor gains by receiving the stock of the acquiring company in exchange. A number of factors, such as failure to obtain requisite approvals, may prevent a deal from going through. The spread between the prices exists due to this uncertainty and the size of spread depends on the time period.
This can be preemptive or post-tender arbitrage. In preemptive arbitrage, the investor purchases the stock of an anticipated target firm. It is speculative in nature and the investor runs the risk that the company is not acquired.
In post-tender arbitrage, the investor purchases the stock of the target firm after the announcement of a proposed acquisition. The gains are comparatively smaller and there is a significant risk that the deal will fall through.