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 ...view middle of the document...
5M or 260,000 shares of Alza purchased for the long position. The number of Abbott shares shorted is then found by multiplying the number of shares of Alza purchased by the Announced Exchange Ratio of 1.2 ABT:1.0 AZA, which yields 312,000 shares of Abbott that are to be shorted.
Potential and Expected Returns
The bet’s “payoff” is reflected in the spread between the market values of consideration to be received in the deal (acquirer’s stock, cash) minus the market values of securities to be given up (target’s stock).
Gross Spread (Per Share) = Value to be Received in the Transaction - Stock Price of Target
= Value of Abbott Shares to be Received - Price of Alza
= (43.50 x 1.2) - 48.00
Gross Spread (Total) = (43.50 x 312,000 shares) - (48.00 x 260,000 shares)
= 13,572,000 - 12,480,000
Net Spread = Gross Spread (total) ± All Other Cash Flows from Investment
= Gross Spread - Margin Interest + Short Sale Rebate
= 1,092,000 - ((6.2% x 50% x 12,480,000 x (191/365)) + (5.6% x 13,572,000 x (191/365))
= 1,092,000 - 202,450 + 397,715
Potential ROI = Net Spread / Total Capital Employed
= 1,287,265 / ((50% x 13,572,000) + (50% x 12,480,000))
= 1,287,265 / 13,026,000
Annualized Potential ROI = Potential ROI x (365 / Number of Days until Completion)
= 10.1% x (365/191)
3) Why would you expect positive excess returns from a risk arbitrage strategy? Why wouldn’t market efficiency prevent such profits from persisting? Do you believe the strategy will be profitable in the long run?
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...