Merger arbitrage involves trading shares of companies involved in a possible merger to take advantage of price discrepancies before and after the merger. An investor buys shares in the company being acquired and sells shares in the acquiring company as a hedge. The strategy benefits from the time between the announcement and the deal, but is risky due to potential merger failure and bear markets.
Merger arbitrage is an investment technique in which someone invests trades the shares of companies involved in a possible merger. The strategy aims to take advantage of the price discrepancies of the companies before and after the merger. An investor who practices merger arbitrage will buy shares in a company that is about to be acquired in a merger that expects a price increase when it goes through. This investor will also often sell shares in the acquiring company in hopes of a price decline for that company and also as a hedge against the failure of the merger.
Arbitrage refers to the practice of buying shares with the intention of immediately selling them back at a higher price. In the case of merger arbitrage, this occurs when rumors of a merger between two companies begin to circulate. The person making the trade, also known as an arbitrageur, believes an impending merger presents an ideal time to pounce on a rare market inefficiency.
When a merger is looming, an arbitrageur will focus on going long on the company being acquired, meaning he will buy the shares. This transaction is usually accompanied by the acquiring company’s arbitrage short selling actions. At a later date, the arbitrageur will likely buy these shares back, ideally at a much lower price than they sold.
The greater the difference between the current price of the target company and the price at which they will eventually be bought in the merger, the better the outcome of the arbitrage transaction. Merger arbitrage also benefits from the sometimes extended time between the time the merger is announced and the deal actually taking place, allowing the benefits of the price discrepancy to multiply for the investor over that period. If this occurs and the acquiring company’s shares fall based on the increase in the acquiree’s shares at the purchase price once the merger is finalized, the arbitrageur has a chance to make a significant profit.
There are several dangers that make merger arbitrage a risky maneuver. Most damaging is when a merger fails, which can result in the stock of the company that should have been acquired falling. Another potentially damaging situation is a bear market, which could cause shares to decline despite the impending merger. This is another reason why shorting the acquiring company is important, as it acts as a hedge in situations where the prices of both companies move in the same direction.
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