What are the risks involved in Arbitrage?

In the media or news, there are always reports about one company being merged or bought by another rival company. Mergers and acquisitions are a fundamental part of a company’s business cycle. In their quest to find sustainability, numerous companies merge with other companies to ensure business synergy and that they can use the resources and the customer base of the other company to expand. Apart from mergers, companies acquire different companies that are not performing well and have been realizing constant losses for several years. These companies are those which were once doing good business but slid into losses because of an unforeseen event or bad management.

Big companies are always on the lookout for merging or acquiring a company to push their business to better profitability. The scout for such companies who are not currently doing well but have huge potential if provided with needed resources. They make an offer to buy the companies, and if accepted, the merger or the acquisition is successful.

As they enter the financial market to make profits, the news of a merger or acquisition is in the investor’s interest and they execute numerous strategies to use the price movement to make profits. Among various strategies, Risk Arbitrage is the most widely used. But before you understand Risk Arbitrage trading, you need to know about the concept of Arbitrage.

What is Arbitrage?

Various assets are traded in high volume across different exchanges in India. However, due to market inefficiencies and differential demand-supply, the price of the asset classes may vary across platforms. For example, you may have noticed that the shares of a particular company have a different prices on the National Stock Exchange and the Bombay Stock Exchange. When this happens, investors see profit potential.

Arbitrage is the simultaneous buying and selling of any of the securities, such as stocks, commodities, bonds, currencies, etc., in different markets to profit from the price difference. These investors, called arbitrageurs, research the price difference and buy the security from one market at a lower price and sell it in another market where the price is high.

What is Risk Arbitrage?

Risk arbitrage or Merger Arbitrage is one of the most common strategies in the capital markets. This strategy entails buying stocks that are in the process of a merger or acquisition, or amalgamation. Merger arbitrage is popular among hedge funds with a higher risk appetite. They buy the target company’s stocks and short-sell stocks of the acquirer. Such strategies are normally leveraged using futures contracts with the company’s stocks as the underlying asset.

This form of Arbitrage is an event-driven trading strategy that speculates the rise or fall in both the acquirer and acquiring company’s share prices. If the investors believe that they will increase or decrease, they execute the risk arbitrage strategy to benefit from the price movement. Since the price of the acquiring company may rise after the news of the acquisition, the investors take a long position for the shares. However, as they believe the shares of the acquirer company may fall at the same time, they take a short position in the stock simultaneously to create a hedge.

How does Risk Arbitrage work?

Risk Arbitrage is one of the most complex stock market strategies professional investors use to benefit from a merger or acquisition. To understand the working of risk arbitrage, you can consider reading the following detailed example:

Suppose a company XYZ’s stocks are trading for Rs 500. After the closing of the stock market, another company, ABC placed an open offer to buy XYZ at a 20% premium or Rs 600 per share. This news instantly becomes public and reaches investors who believe that the positive news will increase XYZ’s share price in the next stock market session. The price may go up to Rs 600 as investors believe it is the fair value of the company’s shares, or else ABC wouldn’t have made the offer at this price.

However, acquisitions always come at a risk of not going through because of legal obligations, auditing reasons, economic developments, regulatory challenges, etc. The uncertainty forces the shares of XYZ to hover near the Rs 600 level. For example, it may trade at Rs 530, Rs 550, Rs 570, and so on. The nearer XYZ’s share price is to Rs 600, the more chances of the acquisition deal being successful.

Order 1: The Long Position

Based on the speculation that XYZ’s company’s price may rise from Rs 500 to Rs 600, an investor places a long order to buy 100 shares of XYZ as soon as the market opens. If the order is executed at Rs 530, the investor can sell all the shares at Rs 600 or when the acquisition deal is successful. The transaction will earn the investor a profit of Rs 7,000 (Rs 60,000-53,000)

Now, since the investor placed a long position for XYZ’s stocks, the next transaction is to short the shares of ABC. This is because, as ABC will bear the cost of acquiring XYZ, its share price may decline because of the huge spending. Suppose ABC was trading at Rs 1,500, and the investor expects its share price to decline to Rs 1,200. The investor will place a short call.

Order 2: The Short Position

Based on the speculation that ABC company’s price may fall from Rs 1,500 to Rs 1,200, an investor places a short order to buy 100 shares of ABC as soon as the market opens. If the order is executed at Rs 1,450, the investor can wait for the price to go down to Rs 1,200 or when the acquisition deal is successful. The transaction will earn the investor a profit of Rs 25,000 (Rs 1,45,000-1,20,000).

This is how risk arbitrage trading works in the stock market and allows investors to make profits from placing a long position and a short position simultaneously

What are the risks involved in Risk Arbitrage?

As risk arbitrage strategy is one of the hardest to execute, it comes with the following risks for the hedge fund or the investor:

• Difficulty in Tracking: Developments about mergers and acquisitions are tough to track as they happen instantly and without prior notice. Furthermore, if tracked, there is no promise that the news is reliable. As it can turn out to be false, investors who have taken long and short positions under risk arbitrage may end up losing their investments and incur huge losses.
• Deal Risk: Deal risk is the risk an investor takes in case the acquisition deal does not go through. If it fails, it can create negative repercussions on both the company’s prices, forcing the investor to lose a hefty amount of money.
• Price Fall: As investors only speculate that the share price of the acquiring company may rise, it may be that it falls to very low levels. In such a case, investors may lose money on their long positions.
• Uncertain Timeline: Entering into risk arbitrage only after the acquisition or merger news is risky as you can never know how much time it will take for the deal to go through. It can take months, allowing traders to enter into derivatives of the stocks and forcing the stock price to fluctuate.

Mergers and acquisitions happen regularly, some go through, and some don’t. Risk arbitrage is an effective strategy to leverage such deals and make considerable profits in the process. However, as the strategy is complex to execute and comes with numerous potential risks, it is also wise to consult a financial advisor such as IIFL. Once you know how to plan and execute the strategy, you can go ahead and benefit from the numerous deals that happen daily. For more information about risk arbitrage, visit IIFL’s website or download IIFL’s Markets app from the app store.