Risk arbitrage, also called merger arbitrage, is a form of speculation on the outcome of takeover bids. It is essentially an absolute return strategy and should usually be market neutral. It should make high returns based on inefficiencies in the market that occur during the bid process. This is the similarity to true arbitrage that gives risk arbitrage its name.
Neither risk arbitrage nor merger arbitrage is really a perfect description of the process, even apart from the fact that it is not arbitrage. The greatest opportunities come from takeover, not mergers (because the price movements are greater). The term risk arbitrage merely describes it as being an arbitrage like but risky strategy, something that also applies to many other strategies such as statistical arbitrage.
The price movements that take place during a takeover tend to follow pattern. The price of the target usually rises, and the price of the acquirer usually falls, when a bid is announced (or even rumoured, or otherwise anticipated). The extent to which the prices move depends on various uncertainties, and as news flows the prices will continue to fluctuate during bid process, as news changes investors' assessments of:
- the chances of the bid succeeding,
- the chances that regulators will allow the bid,
- what conditions regulatory approval might depend on,
- the likelihood that the acquirer might raise the price, or terms (payment in cash or shares).
This does create opportunities for specialists who are better able to assess the risks of the bid process. The process creates a lot of information that most investors are ill-equipped to process. This means that there frequently is an inefficiency in the market as this information is not reflected in prices.
The simplest risk arbitrage trade would be to simply buy or short the target. A more typical approach would be to buy the target and short the acquirer, and profit from the price movements should the bid succeed or the price be raised. An arbitrageur who expects the bid to fail would, similarly, short the target and buy the acquirer. This is similar to the pair trading strategy used for simple statistical arbitrage. If the target and the acquirer are in the same sector, this is market neutral.
The scope for risk arbitrage obviously depends on the level of M & A activity, and on how efficiently the marker reacts to what activity there is.