For event driven merger arbitrage they say:
Payoff is like selling insurance- risk less bond and short put option. White Knight is like adding a call???
I do not get this
Could you be more detailed. Unfortunately we do not have the luxury to access 2020 curriculum.
Well if I understood it well it should be like this: It is an option because nothing is guaranteed that the deal would go through in the first place. If the deal goes through, you get more money than by simply going long because the two acquirers would need to outbid each other. This is the reason why it is a call because there is a somewhat greater benefit than standard upside.
Excert from the 2020 text book.
Corporate events are typically binary: An acquisition either succeeds or fails. The merger arbitrage strategy can be viewed as selling insurance on the acquisition. If the acquisition succeeds (no adverse event occurs), then the hedge fund manager collects the spread (like the premium an insurance company receives for selling insurance) for taking on event risk. If the acquisition fails (an adverse event occurs), then he/she faces the losses on the long and short positions (similar to an insurance company paying out a policy benefit after an insured event has occurred). Thus, the payoff profile of the merger arbitrage strategy resembles that of a riskless bond and a short put option. The merger arbitrage investor also can be viewed as owning an additional call option that becomes valuable if/when another interested acquirer (i.e., White Knight) makes a higher bid for the target company before the initial merger proposal is completed. Exhibit 5 shows risk and return attributes of merger arbitrage investing.
I have the same question, why the payoff profile resembles a riskfree bond plus shorting a put option?
Thanks a lot.
I have the same question too
MA - Target Buy, Acquirer sell
In my opinion, and as per the CFA curriculum “Approximately 70%–90% of announced mergers in the United States eventually
close successfully. Given the probability that some mergers will not close for whatever
reason as well as the costs of establishing a merger arbitrage position (e.g., borrowing
the acquiring stock, commissions) and the risk that merger terms might be changed
because of market conditions (especially in stressed market environments), merger
arbitrage typically offers a 3%–7% return spread depending on the deal-specific
risks.”.
Now, since, the MA investor is expecting 70%-90% of the time, that the Merger will go through, hence, a typical return of 3%-7% is almost certain - hence, riskless bond.
However, if the Deal does not go through and the Target price falls and Acquirer price rises, the investor suffers loss due to Merger failing or going down, hence, the Short Put, in which case the seller of insurance on Merger - the investor has to incur Outflow of funds to square off the MA position.