Merger arbitrage involves trading shares of companies involved in a potential merger to take advantage of price discrepancies before and after the merger. The strategy involves buying shares of the company to be acquired and selling shares of the acquiring company as a hedge against the failure of the merger. The practice can be risky due to the possibility of the merger not taking place or a bear market causing stocks to drop.
Merger arbitrage is an investment technique in which an investor trades the shares of companies involved in a potential merger. The strategy aims to take advantage of the price discrepancies of the companies before and after the merger. An investor practicing merger arbitrage will buy shares of a company that is about to be acquired in a merger and expects a price increase when it takes place. This investor will often also sell shares of the acquiring company in the hope of a price drop 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 reselling them at a higher price. In the case of merger arbitration, this occurs when rumors of a merger between two companies begin to circulate. The person making the trade, also known as an arbitrator, believes that an impending merger represents an ideal time to attack a rare inefficiency in the market.
When a merger looms, an arbitrageur will focus on spending a lot of time on the company to be acquired, which means that he or she will buy its shares. This transaction is usually accompanied by arbitrage of the acquiring company’s short selling shares. At some point thereafter, the arbitrator will likely buy these shares back, ideally at a much lower price than what they sold for.
The greater the difference between the current price of the target company and the price at which they will eventually be purchased in the merger, the better the transaction will turn out for the arbitrator. Merger arbitrage also benefits from the sometimes extended time between the time the merger is announced and the deal actually goes through, allowing the benefits of the price discrepancy to multiply for the investor during that time. . If that occurs, and the acquiring company’s shares fall in line with the increase in the acquired company’s shares at the purchase price after the merger is finalized, then the arbitrator has an opportunity to make a significant profit.
There are several dangers that make merger arbitrage a risky move. The most detrimental is when a merger does not take place, which can lead to the fall in the shares of the company that was supposed to be acquired. Another possibly detrimental situation is a bear market, which could cause stocks to drop despite the impending meltdown. That is another reason why shorting the buying company is important, as it acts as a hedge in situations where the prices of both companies are moving in the same direction.
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