Event driven trading strategies seek to exploit relative mispricings between securities whose issuers are involved in mergers, divestures, restructurings or other corporate events. The strategies are generally leveraged and are often implemented to be market neutral. They are widely employed by certain hedge funds and proprietary traders. The quintessential event driven strategy is merger arbitrage, which is also called risk arbitrage. This is a strategy of providing liquidity to owners of a stock that is currently the target of an announced acquisition. When one corporation announces an intention to acquire another, it generally offers to buy the target firm's stock at a premium over the current market price. Upon that announcement, the target firm's stock price generally rises to a level just below the offer price. It won't rise to the offer price because of uncertainty about the merger actually taking place. Much can happen to derail a planned merger. Regulators might block the merger on antitrust grounds. Shareholder might feel the merger is not in their best interest and vote to block it. Unanticipated events, such as a market crash or war, might intervene and make the merger infeasible in the new economic or geopolitical environment. If the merger fails to go through, the targeted firm's stock price will immediately fall, often to a level below where it was before the merger was announced. This is called deal risk, and it poses a quandary for the target firm's shareholders. Should they immediately sell their shares in the market and lock in the current price, or should they hold out, hoping the merger goes through, but risking a loss if it doesn't? Many choose to sell, and it is merger arbitragers who are their buyers. Merger arbitragers are experts in assessing deal risk. They hire lawyers to dissect deals and anticipate things that might go wrong. They look at the economic and geopolitical environment. They assess the mood of shareholders. They look at the spread between the offered price and current market price for the target firm's stock. They assess how much of it is due to deal risk and how much of it is a liquidity spread reflecting pent up demand of shareholders wanting to sell. If they feel the liquidity spread is high enough, the arbitragers will step in and buy the stock. They capture the spread in exchange for bearing the deal risk. Merger arbitragers hedge their position by simultaneously shorting the acquiring firm's stock. This provides them with a crude market neutral hedge, but it increases their exposure to deal risk. Usually, an acquiring firm's stock price declines slightly prior to a merger. This is especially true if investors perceive the acquiring firm as overpaying for the acquisition. If the merger goes through, an arbitrager will profit from further decline in the acquirer's stock price. If the merger fails, he will lose as the acquirer's stock price rebounds. Other event driven strategies entail investing in divestitures or new stock issuances. Many involve investing in corporations that file for bankruptcy or are otherwise distressed. A unifying element in most of these strategies is that the arbitrager profits by providing liquidity—buying what others want to sell or selling what others want to buy. The strategies tend to make consistent profits, but they can suffer occasionally staggering losses. As with many market neutral strategies, event driven strategies have return distributions that tend to be negatively skewed and leptokurtic.
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