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What is a Merger Arbitrage And How Does It Work

15 Sep 2023

Introduction

Making money out of the stock market's inefficiency is known as arbitrage trading. Since it is not a very ethical way, stock exchanges try their best to eliminate such practices. However, merger arbitrage is still possible in India. Moreover, those who practice it are known as arbitrageurs. Merger arbitrage is popular among hedge funds and traders to make risk-free profits. So, here is everything about merger arbitrage, from its definition to execution.

What is Merger Arbitrage?

Merger arbitrage is a profit-making opportunity in trading. It occurs due to a merger or acquisition event. It means this opportunity is an event-driven trading practice. Moreover, it is also known as risk arbitrage. The profit in a merger arbitrage is made from the market's inefficiencies due to a merger or acquisition deal.

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There are two types of merger arbitrage. The first is a cash merger, which is an all-cash deal. The acquiring company buys the shares for cash. The second one is stock for stock. It means the acquiring firm offers its stocks to get the targeted firm's stocks.

How Does a Merger Arbitrage Work?

Firstly, a merger arbitrage requires two companies to either merge or one company to acquire the other. The company that will acquire or merge with the other company is called the acquiring company. Moreover, the one being merged with or acquired is called the target company. Now, let's understand how it works.

When a company decides to acquire another company, the news spreads. So, the hedge fund managers and traders analyze if the acquisition or merger will actually happen. If they find the acquisition probability very high, they take a long position in the target company. But why?

Due to the news, the acquiring company's stock price drops. However, the target company's stock price remains below the price announced by the acquiring firm to acquire the target company. It is because the acquisition news is still not confirmed. At this point, the arbitrageurs buy the shares of the target firm. If the deal is a success, there is a hike in the price of the target company for the following years and this makes the arbitrageur's trade profitable.

But, if the merger deal breaks, it leads to a loss. The reason is a price drop in the targeted firm's stock. In such cases, the arbitrageurs short the shares.

Summing Up

Merger arbitrage can be great, but only if the merger happens. There can be many reasons for which a deal may break, such as taxation issues or regulations. Merger arbitrage is rare, as the events of merging and acquisition do not frequently occur. If you also want to profit in the stock market with your knowledge, open a Demat Account only with Motilal Oswal.

 

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