Could anyone explain how a merger is like selling insurance?
Merger arbitrage seeks to capture a spread in case of merger success.
You buy the target’s shares and short the acquirer’s shares in the proportion given by the exchange ratio and if the deal succeeds you receive shares of the acquirer in exchange of the target’s shares which are used to cover your shorts of the acquirer’s shares.
But you bear the risk of deal failure.
You sell insurance (liquidity to be more accurate) to the investors who do not want to bear the risk of owning the target’s shares anymore in exchange of the risk premium for accepting that risk.
If the deal is a success you get the premium.
If the deal is a failure you must pay an unknown amount that can far exceed the premium received.
Hope this helps.
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