Profiting Risklessly discusses two of the
through Special more common arbitrage
Operations operations - those
arising from mergers and
Arbitrage (sometimes liquidations – as well
called “risk arbitrage” as the formula necessary
or “merger arbitrage”) to value the potential
is a special type of return on capital
investment operation employed.
that is meant to
generate profit with Corporate Mergers and
little or no risk. By Acquisitions
taking advantage of
special situations that When a publicly traded
arise in the security company is acquired, the
markets from time to acquiring entity makes a
time, an investor can tender offer to the
exploit price current shareholders
discrepancies created by inviting them to sell
special situations, their stock at a price
increasing his net worth usually above the quoted
regardless of whether price on the exchanges
the market itself or over-the-counter
advances. This article market.
A Fictional Example of market price and the
Risk Arbitrage in tender price. It is
Mergers and hardly practical to make
Acquisitions a significant profit by
attempting to jump into
Acme Industries, Inc. the market the moment a
decides to acquire one tender offer is
hundred percent of Smith announced; very few
Enterprises. Smith’s shares could be acquired
stock trades on the before the price had
over-the-counter market been driven up due to
and is quoted at $15 per the sudden demand
share. Acme’s management flooding the market from
makes a tender offer in would-be arbitragers.
the amount of $25 per Instead, two methods of
share. This means that risk arbitrage developed
for a few, brief which I call pre-emptive
moments, an arbitrager and post-tender. In the
can buy shares of Smith former type of
Enterprises for $15 each operation, the
on the open market, turn arbitrager purchases
around and tender (i.e., shares of a company
sell) them to Acme for which he believes will
$25. Through this be taken over in the
operation, the coming days or months.
arbitrager has made a If he turns out to be
quick profit of $10 per correct, he will fully
share from the spread benefit from
that existed between the
the spread between the been announced by a
price he paid and the potential acquirer.
tender offer. The risk Despite the $25 standing
he runs, however, is offer Acme has made for
that a company is not the common stock of
acquired. Since he must Smith Enterprise, it may
rely on rumors and gut sell for only $24.00 on
feeling to predict which the market (the reason
companies will be for this discrepancy is
acquired and for what too complicated and time
price, pre-emptive consuming to be of value
arbitrage is inherently to the average
more speculative in investor). This
nature than its difference of $1.00 per
counterpart. As a share may seem small;
result, it tends to be looks can be deceiving.
far less profitable on Due to the short amount
the whole. of time the investment
is held, the indicated
Post-tender arbitrage, annual return on such a
however, deals only in commitment is remarkably
situations where a high.
tender offer has already
Graham’s Indicated = [GC – L (100% - C)] ?
Annual Return Formula YP
for Risk Arbitrage
Let G be the expected
To calculate the value gain in points in the
of a potential arbitrage event of success;
commitment, Benjamin L be the expected loss
Graham, the father of in points in the event
value investing created of failure;
the following formula, C be the expected chance
which he discussed in of success, expressed as
length in the 1951 a percentage;
edition of Security Y be the expected time
Analysis; its creation of holding, in years;
was heavily influenced P be the current price
by Meyer H. Weinstein’s of the security
classic 1931 book,
Arbitrage in Securities
(Harper Brothers).
Indicated annual return
