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Merger arbitrage, also known as risk arbitrage, mainly refers to the strategy that attempts to profit from the price discrepancy between the stock price of the target company immediately following the merger announcement and the bid price that is offered by the acquiring company. Typically, the target company’s stock trades at a discount relative to offer price. This difference is known as the arbitrage spread. Arbitrageurs usually long target stocks and short acquirer stocks at the same time trying to capture the arbitrage spread. Merger arbitrage is risky in that the announced merger deal may or may not succeed. If the merger deal goes through, arbitrageurs successfully capture the arbitrage spread. However, if the merger deal falls apart, both the target and acquirer stock prices could move adversely and merger arbitrageurs can suffer a much larger loss than the profits if the deal succeeds.
Recent years have witnessed increased attention to merger arbitrage. While both academia and practitioners have examined merger arbitrage extensively, their focus on merger arbitrage is very different for various reasons. Academia typically focuses on the implications of merger arbitrage activities on stock prices or market efficiency. For instance, Mitchell et al. (2004) investigate the implications of merger arbitrageurs on stock prices; they estimate that nearly half of the negative announcement period stock price reaction for acquirers in stock-financed mergers reflects downward price pressure caused by merger arbitrage short selling acquirer stocks. Baker and Savasoglu (2002) examine the limits of arbitrage using a sample of merger and acquisitions and conclude that abnormal merger arbitrageurs’ profits mainly stem from market inefficiency that is caused by limits of arbitrage.
In comparison, practitioners, especially merger arbitrage hedge funds, concentrate more on the practical aspects of merger arbitrage such as the profitability of merger arbitrage and its implementation in capital markets. On the profitability side, Baker and Savasoglu (2002) examine merger arbitrage in US and find an abnormal return of 0.6-0.9% per month over the period 1981 to 1996 for their diversified portfolio of merger arbitrage positions. Sudarsanam and Nguyen (2007) examine profitability of merger arbitrage using UK cash and stock mergers. Their arbitrage portfolio generates a risk-adjusted return of 0.94% per month. Maheswaran and Yeoh (2005) examine merger arbitrage profitability using Australia data. They find similar returns to their merger arbitrage portfolios, ranging from 0.84% to 1.2% per month. It is noteworthy that all these papers focus exclusively on stock-based merger arbitrage and none of them examines the profitability and implementation of option-based merger arbitrage. This paper tries to fill in the gap by horse-racing the profitability of stock-based and option-based merger arbitrage.
In a recent paper, Jetley and Ji (2010) notice a sharp decline of over 400 basis points for the merger arbitrage spread since 2002. They explore why the merger arbitrage spread declines over time.1 More importantly, they argue that some of the decline in arbitrage spread is likely to be permanent. Meanwhile, the hedge fund literature also provides evidence that hedge funds have witnessed decreased hedge fund alpha over the last decade. For instance, Naik
et al. (2007) and Fung et al. (2008) document that the overall level of hedge fund alpha has been on decline throughout the last decade. Zhong (2008) argues that this decline in hedge fund alpha is consistent with hedge fund capacity constraint, which can result from the limited profitable opportunities in the market.
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