Arbitrage refers to the practice of buying shares in order to immediately resell them at a higher price. In the case of merger arbitration, this occurs when rumors begin to circulate about a merger between two companies. So what is merger arbitrage?
Key Points of the Merger Arbitrage
Merger arbitrage involves simultaneously buying and selling the respective shares of the two merging companies for a “risk-free” profit. Since there is uncertainty about the completion of the transaction, the target company’s share price is usually sold at a price below the purchase price. The merger arbitrator will consider the possibility that the merger will not be completed on time, or not completed at all, and will then buy the shares prior to the acquisition, expecting to make a profit upon completion of the merger or acquisition.
Typical merger arbitrage trading strategies take advantage of the difference between the current share price of the acquired company and its final transaction price. Standard merger arbitrage in a cash acquisition involves buying the shares of the target company at a lower market price in the hope that the transaction will succeed and rise to the transaction price. The development of a merger or acquisition procedure requires a prudent approach and careful preparation. However, these actions do not exclude the possibility of failure.
Arbitrage can be used whenever any stock, commodity, or currency can be bought in one market at a given price and simultaneously sold in another market at a higher price. The situation creates an opportunity for risk-free profit for the trader. When conducting a merger arbitrage, the goals of the seller, the company, and the investor complement each other but are not identical. The role of the investment bank that manages or sponsors the deal is to ensure that the interests of all three parties are balanced.
What Is a Merger Arbitrage Example?
Merger arbitrage presents a simultaneous short position in the stock of the acquiring company after the takeover bid is announced. Uncertainty in the market contributes to the manifestation of significant interest in such transactions from the investment community of a special type, which completely ignores all kinds of technical analysis and pays close attention to the quintessence of investing namely, qualitative and quantitative analysis.
Merger arbitrage seeks to profit from the differential or spread between the price offered for the target stock and the current price, and the decline is often witnessed in the buyer’s share price (which can be for various reasons such as a buyer who is to pays a lot for the goal, taking on too much debt to finance the purchase, lack of synergy, etc.).
Merge arbitration examples support the following types of mergers and acquisitions:
- A cash-out merger is in which one company offers to buy the shares of another company at a specified price.
- A stock-for-stock merger in which one company offers to buy another by exchanging its own shares for shares in the target company.
It is important to understand not only the interests of shareholders but also the issuer. Imagine a large company that does not find a market with sufficient potential to invest free funds. The absence of a new direction for development may affect future financial and operating results. The benefit of the company can be associated not only with the investment of its own funds. The reason for share repurchase may be protection from hostile takeovers, a desire to save on taxes and increase the market value of shares.