Post on 10-Jul-2016
Warwick Business School
Chendi Zhang
Warwick Business School
Lecture outline
definition and workings
recent empirical evidence on arbitrage spreads and returns to merger arbitrage hedge funds
Jetley and Ji (FAJ 2010)
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Definition
merger arbitrage is a form of speculation on the outcome of takeover bids
takes place after the deal announcement
if before the deal announcement – problem with private information as trading on private information is illegal
playing on the probability of a deal completing
sometime also referred to a risk arbitrage (a broader term)
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Definition
it takes advantage of the arbitrage spread
arbitrage spread is the difference between the acquisition price and the price at which the target’s stock trades before the consummation of the merger
the arbitrage spread is realized over the period between the merger’s announcement and its consummation (105 days, time value of money)
a discount on the offer price due to probability of the deal going through is smaller than one
so, merger arbitrage bears the risk that the deal might not be successfully completed → merger arbitrage is a risky strategy (so it is not really an arbitrage)
but still, merger arbitrage seems to be associated with large excess returns (a frequent hedge fund strategy)
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Example
on 10 July 2008, the Dow Chemical Company announced the acquisition of Rohm and Haas Company (ROH) for $78.00 a share in cash
in response to the announcement, ROH’s stock price increased by more than 60% to close at $73.62
the arbitrage spread at the close of the NYSE on 10 July 2008 was $4.38, or 5.9% ($4.38 as a percentage of $73.62)
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Target returns for a successful deal
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Target returns for an unsuccessful deal
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Trading strategy
depends on the payment consideration
in all-cash offers, the arbitrageur goes long on the target stock and gets money for his shares when the deal is completed
arbitrage spread is then 𝑃𝑜𝑓𝑓𝑒𝑟 − 𝑃𝑡𝑎𝑟𝑔𝑒𝑡,𝑡
𝑃𝑡𝑎𝑟𝑔𝑒𝑡,𝑡
in all-stock offers, the strategy has to take into account that target shareholders are paid by the acquiring firm stock
so if an arbitrageur only went long on the target shares, he would be exposed to price movements of the acquiring firm stock
to avoid this, he shorts acquiring firms stock in exact proportion to the stock payment consideration (exchange ratio 𝑥)
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Trading strategy
shorting the acquiring firm stock is straightforward in fixed exchange ratio stock offers when a fixed exchange ratio is announced together with the deal
one shorts the acquiring firm stock in proportion to the exchange ratio
example: if I get 𝑥 acquiring firm shares for each share of the target, I have to short 𝑥 ∗ 𝑁 , where 𝑁 is the number of target firm shares I bought
the arbitrage spread is then 𝑃𝑎𝑐𝑞,𝑡∗𝑥 − 𝑃𝑡𝑎𝑟𝑔𝑒𝑡,𝑡
𝑃𝑡𝑎𝑟𝑔𝑒𝑡,𝑡
in floating exchange ratio deals, the risk is eliminated only once the exchange ratio is set during the pricing period
pricing period is usually later in the process
one shorts only once the exchange ratio is set
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Successful trading strategy
several studies have reported large excess returns related to the merger arbitrage investment strategy
Larcker and Lys (1987), Mitchell and Pulvino (2001), Baker and Savasoglu (2002), and Jindra and Walkling (2004)
several reasons have been suggested for the excess returns
excess return represents compensation for acquiring costly private information
arbitrageurs risk running out of capital when the best opportunities exist, and thus, they become more cautious when they make their initial trades; this action, in turn, limits their ability to price away any inefficiencies
excess returns represent compensation for providing liquidity, especially in down markets
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Merger arbitrage hedge funds
popularity of merger arbitrage as an investment strategy has grown over the years
the assets under management of merger arbitrage hedge funds grew from $233 million at the end of 1990 to $28 billion by the end of 2007 (Hedge Fund Research 2008)
event-driven arbitrage funds were able to generate positive alphas of about 1% a month (Agarwal and Naik, 2000)
risk arbitrage generates risk–return profiles that are superior to those of other hedge fund strategies (Ackermann et al., 1999)
recently, studies have documented the general decline in merger arbitrage hedge fund alphas (Fung et al, 2008)
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Evolution of arbitrage spread
Jetley and Ji (FAJ 2010), data over 1990-2007, US companies
completed and failed
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Evolution of arbitrage spreads
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Median arbitrage spread, successful deals
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Returns of merger arbitrage hedge funds
monthly return data from the HFRI Merger Arbitrage Index
the medians of monthly returns are 96 bps over 1990-95, 99 bps over 1996-01, and 51 bps over 2002-07
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Reasons for the decline in the arbitrage spread
transaction costs
direct cost – declining since 1990 (from 64bsp to 11bsp between 1990-2006)
indirect cost – price impact of trades, declined as well due to increased liquidity
compare arbitrage spreads of successful deals on the day completion was announced (risk is zero and time value of money is negligible)
62 bps over 1990-95, 62 bps over 1996-01, and 6 bps over 2002-07 (for cash deals)
107 bps over 1990-95, 82 bps over 1996-01, and 51 bps over 2002-07 (for stock deals)
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Reasons for the decline in the arbitrage spread
capacity constraints (more money chasing a limited number of deals)
between 1990 and 2007, net inflows into merger arbitrage hedge funds were equal to $18.3 billion, of which $14.8 billion was attributable to net inflows since 2000 (HFR, 2008)
check trading volume in the target stock subsequent to the merger announcement (relative to normal level of volume)
industry insiders have estimated that, on average, arbitrage funds own as much as 50% of the target
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Relative volume
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Relative volume, successful deals
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Reasons for the decline in the arbitrage spread
reduction in risks associated with risk arbitrage
completion risk – compare success rates over time – it remained relatively stable though
uncertainty about the loss in the event of failure
○ check the bid premium – the average bid premium declined from 45% for 1996-01 to 36% for 2002-07 and the difference between the means is statistically significant
○ also, the probability that targets in failed transactions may be involved in subsequent transactions increased over 2002-07, such that the targets’ stock prices did not revert to pre-merger levels
other risk factors concern deal terms and time to consummate
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Summary
what is merger arbitrage?
definition, strategies, risks
development of arbitrage spreads excess return on merger arbitrage hedge funds since 1990s
they declined and are likely to remain relatively low
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References
Jetley and Ji, 2010, ‘The shrinking merger arbitrage spread: Reasons and implications,’ Finanicial Analyst Journal 66 (2), 54–68.
Larcker and Lys, 1987, ‘An empirical analysis of the incentives to engage in costly information acquisition: The case of risk arbitrage,’ Journal of Financial Economics 18, 111–126.
Mitchell and Pulvino, 2001, ‘Characteristics of risk and return in risk arbitrage,’ Journal of Finance 56, 2135–2175.
Baker and Savasoglu, 2002, ‘Limited arbitrage in mergers and acquisitions,’ Journal of Financial Economics 64, 91–115.
Jindra and Walkling, 2004, ‘Speculation spreads and the market pricing of proposed acquisitions,’ Journal of Corporate Finance 10, 495–526.
Agarwal and Naik, 2000, ‘On taking the ‘Alternative’ Route: Risks, rewards, and performance persistence of hedge funds,’ Journal of Alternative Investments 2(4), 6–23.
Ackermann, McEnally, and Ravenscraft, 1999, ‘The performance of hedge funds: Risk, return, and incentives.” Journal of Finance 54, 833–874.
Fung, Hsieh, Naik, and Ramadorai, 2008, ‘Hedge Funds: Performance, risk and capital formation,’ Journal of Finance 63, 1777–1803.
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