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
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
position by simultaneously shorting
the acquiring firm's stock. This provides them with a crude
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
neutral strategies, event driven strategies have
return distributions that tend to be
negatively skewed and
A transaction which generates a risk-free profit.
A trading or investment strategy that entails taking net long or short
positions in a market.
fund A largely unregulated investment fund that specializes in
taking leveraged speculative positions.
leverage Debt financing or anything that can similarly magnify the risk
and reward of an investment.
Term used in various senses, all relating to availability of, access to, or
convertibility into cash.
liquidity risk Risk due to uncertain liquidity.
strategy Speculative trading strategy that seeks to exploit relative mispricings
between instruments while avoiding systematic risk.
market risk Exposure to the uncertain market value of a portfolio.
Arbitrage 31 Oct 2003
Lengthy discussion of merger arbitrage and skewed trading
arbitrage 18 Jun 2000
What is risk arbitrage, and how does it work?