Risk Arbitrage: Abbott Labs & Alza
1) How does risk arbitrage work? What are the risks and opportunities associated with this strategy?
Risk arbitrage, or merger and acquisition arbitrage, is one of three types of arbitrage strategies. Two types of mergers are possible: a cash merger and a stock merger.
Cash Merger Opportunities
Acquirer proposes to purchase the shares of the target for a certain price in cash. Until the acquisition is completed, the stock of the target usually trades below the purchase price. An arbitrageur buys the stock of the target and makes a gain if the acquirer ultimately buys the stock.
Stock-for-Stock Merger Opportunities
Acquirer proposes to buy the target by exchanging its own stock for the stock of
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With a short sale, we have limited the risk of receiving less than the gross spread due to a sharp decrease in Abbott stock price. With a net vs. gross spread difference of $195,265 and a positive ROI, we can expect positive returns after interest and short sale rebate. We expect this because we have hedged against stock price declines and will profit with an increase in Alza after a successful merger. Arbitrage opportunities create a niche in the market that allows for profits to occur. Market efficiency tells us that all current information is shown within the stock price at a given time, but many investors feeling unsure of their position will attempt to liquidate their shares by selling them and thus affecting the stock price. Arbitrage strategies have potential to profit off of mispricing of assets by positioning themselves correctly. It is the liquidity of the these assets that allows the market to contradict the market efficiency. We do expect long term profits from this strategy. With the caveat being the outcome of the litigation. One of the major risks of merger arbitrage is the completion of the deal itself. You also have to consider the time value of money. As litigation progresses, our position becomes less valuable and would create losses. Having accepted these risks and pending litigation, we believe this strategy can create a profitable position in the long run.