Lecture8 Arbitrage Slides

Warwick Business School

Chendi Zhang

2raiyaan

Sticky Note

Hedge funds - wealthy investors have lots of money want to take risks After financial crisis this industry became more regulated because they have been taking too many risks. Led to more monitoring of industry Hedge fund vs mutual fund Hedge funds take more risks (investment style is different) Incentives for fund manager as well is a differnece. Hedge fund managers are payed a bonus depending on performance is similar to PE funds (2+20 structure), bonus of 20%. Profits in hedge funds is not the money the earn, its typically money earned over a threshold. Some firms have a very high benchmark therefore only get 20% bonus if their performance is better over a certain threshold. Merger arbitrage: (hedge funds make investments during events and mergers are seen to be very important events - it fluctuates lots before and after the announcement day. there are lots of rumours. Megrer abtrigae funds try to profit from these rumours. ie. Take advantage of takeover premiums. e.g. When bidder buys target they pay premium. This is profit for arbitraguers. Hedge funds look for price differences. Buy shares after annoucnemnt and sell it after to the bidder at a higher price. (this is basic model of merger arbitrage). Information leakage could still be possible. Doesn't have to be trading on inside information. Buy shares at low price before merger. Key advantage: Have low correlation with the markets. Are event driven. Not that related to the economic cycle i.e. market movements. More focused on event studies. Good for diversification for investors whose other investors are correlated with the market


Lecture outline

definition and workings

recent empirical evidence on arbitrage spreads and returns to merger arbitrage hedge funds

Jetley and Ji (FAJ 2010)

2


Definition

merger arbitrage is a form of speculation on the outcome of takeover bids

takes place after the deal announcement

if before the deal announcement – problem with private information as trading on private information is illegal

playing on the probability of a deal completing

sometime also referred to a risk arbitrage (a broader term)

3

2raiyaan

Sticky Note

Is quite risky: Because deal could collapse or not happen at all


Definition

it takes advantage of the arbitrage spread

arbitrage spread is the difference between the acquisition price and the price at which the target’s stock trades before the consummation of the merger

the arbitrage spread is realized over the period between the merger’s announcement and its consummation (105 days, time value of money)

a discount on the offer price due to probability of the deal going through is smaller than one

so, merger arbitrage bears the risk that the deal might not be successfully completed → merger arbitrage is a risky strategy (so it is not really an arbitrage)

but still, merger arbitrage seems to be associated with large excess returns (a frequent hedge fund strategy)

4


Example

on 10 July 2008, the Dow Chemical Company announced the acquisition of Rohm and Haas Company (ROH) for $78.00 a share in cash

in response to the announcement, ROH’s stock price increased by more than 60% to close at $73.62

the arbitrage spread at the close of the NYSE on 10 July 2008 was $4.38, or 5.9% ($4.38 as a percentage of $73.62)

5

2raiyaan

Sticky Note

Price increased by more than 60% after the announcement. Profit is $4.38 - this profit is risky though. Share price does not immediately go to 73 because deal could collapse. 60% increase indicates the market thinks good deal. For hedge funds this $4 is really good because they are highly levered up. However leverage leads to greater risk for funds


Target returns for a successful deal

6

2raiyaan

Sticky Note

some information leakage b4 announcement. People buying shares before announcement. But on announcement date.


Target returns for an unsuccessful deal

7

2raiyaan

Sticky Note

Risk for unsuccessful deal. 10% (investors already price in uncertainty. Not that positive here)Price going down after day=0. Goes down to initial level.big losses for hedge funds if you bought at day=-1 or day=0


Trading strategy

depends on the payment consideration

in all-cash offers, the arbitrageur goes long on the target stock and gets money for his shares when the deal is completed

arbitrage spread is then 𝑃𝑜𝑓𝑓𝑒𝑟 − 𝑃𝑡𝑎𝑟𝑔𝑒𝑡,𝑡

𝑃𝑡𝑎𝑟𝑔𝑒𝑡,𝑡

in all-stock offers, the strategy has to take into account that target shareholders are paid by the acquiring firm stock

so if an arbitrageur only went long on the target shares, he would be exposed to price movements of the acquiring firm stock

to avoid this, he shorts acquiring firms stock in exact proportion to the stock payment consideration (exchange ratio 𝑥)

8

2raiyaan

Sticky Note

arbitrage spread is profit All cash offers that is profitFor all stock offers - is number of shares in the bidding company. you get certain number of bidding company


Trading strategy

shorting the acquiring firm stock is straightforward in fixed exchange ratio stock offers when a fixed exchange ratio is announced together with the deal

one shorts the acquiring firm stock in proportion to the exchange ratio

example: if I get 𝑥 acquiring firm shares for each share of the target, I have to short 𝑥 ∗ 𝑁 , where 𝑁 is the number of target firm shares I bought

the arbitrage spread is then 𝑃𝑎𝑐𝑞,𝑡∗𝑥 − 𝑃𝑡𝑎𝑟𝑔𝑒𝑡,𝑡

𝑃𝑡𝑎𝑟𝑔𝑒𝑡,𝑡

in floating exchange ratio deals, the risk is eliminated only once the exchange ratio is set during the pricing period

pricing period is usually later in the process

one shorts only once the exchange ratio is set

9


Successful trading strategy

several studies have reported large excess returns related to the merger arbitrage investment strategy

Larcker and Lys (1987), Mitchell and Pulvino (2001), Baker and Savasoglu (2002), and Jindra and Walkling (2004)

several reasons have been suggested for the excess returns

excess return represents compensation for acquiring costly private information

arbitrageurs risk running out of capital when the best opportunities exist, and thus, they become more cautious when they make their initial trades; this action, in turn, limits their ability to price away any inefficiencies

excess returns represent compensation for providing liquidity, especially in down markets

10


Merger arbitrage hedge funds

popularity of merger arbitrage as an investment strategy has grown over the years

the assets under management of merger arbitrage hedge funds grew from $233 million at the end of 1990 to $28 billion by the end of 2007 (Hedge Fund Research 2008)

event-driven arbitrage funds were able to generate positive alphas of about 1% a month (Agarwal and Naik, 2000)

risk arbitrage generates risk–return profiles that are superior to those of other hedge fund strategies (Ackermann et al., 1999)

recently, studies have documented the general decline in merger arbitrage hedge fund alphas (Fung et al, 2008)

11


Evolution of arbitrage spread

Jetley and Ji (FAJ 2010), data over 1990-2007, US companies

completed and failed

12


Evolution of arbitrage spreads

13


Median arbitrage spread, successful deals

14


Returns of merger arbitrage hedge funds

monthly return data from the HFRI Merger Arbitrage Index

the medians of monthly returns are 96 bps over 1990-95, 99 bps over 1996-01, and 51 bps over 2002-07

15


Reasons for the decline in the arbitrage spread

transaction costs

direct cost – declining since 1990 (from 64bsp to 11bsp between 1990-2006)

indirect cost – price impact of trades, declined as well due to increased liquidity

compare arbitrage spreads of successful deals on the day completion was announced (risk is zero and time value of money is negligible)

62 bps over 1990-95, 62 bps over 1996-01, and 6 bps over 2002-07 (for cash deals)

107 bps over 1990-95, 82 bps over 1996-01, and 51 bps over 2002-07 (for stock deals)

16



capacity constraints (more money chasing a limited number of deals)

between 1990 and 2007, net inflows into merger arbitrage hedge funds were equal to $18.3 billion, of which $14.8 billion was attributable to net inflows since 2000 (HFR, 2008)

check trading volume in the target stock subsequent to the merger announcement (relative to normal level of volume)

industry insiders have estimated that, on average, arbitrage funds own as much as 50% of the target

17


Relative volume

18


Relative volume, successful deals

19



reduction in risks associated with risk arbitrage

completion risk – compare success rates over time – it remained relatively stable though

uncertainty about the loss in the event of failure

○ check the bid premium – the average bid premium declined from 45% for 1996-01 to 36% for 2002-07 and the difference between the means is statistically significant

○ also, the probability that targets in failed transactions may be involved in subsequent transactions increased over 2002-07, such that the targets’ stock prices did not revert to pre-merger levels

other risk factors concern deal terms and time to consummate

20


Summary

what is merger arbitrage?

definition, strategies, risks

development of arbitrage spreads excess return on merger arbitrage hedge funds since 1990s

they declined and are likely to remain relatively low

21


References

Jetley and Ji, 2010, ‘The shrinking merger arbitrage spread: Reasons and implications,’ Finanicial Analyst Journal 66 (2), 54–68.

Larcker and Lys, 1987, ‘An empirical analysis of the incentives to engage in costly information acquisition: The case of risk arbitrage,’ Journal of Financial Economics 18, 111–126.

Mitchell and Pulvino, 2001, ‘Characteristics of risk and return in risk arbitrage,’ Journal of Finance 56, 2135–2175.

Baker and Savasoglu, 2002, ‘Limited arbitrage in mergers and acquisitions,’ Journal of Financial Economics 64, 91–115.

Jindra and Walkling, 2004, ‘Speculation spreads and the market pricing of proposed acquisitions,’ Journal of Corporate Finance 10, 495–526.

Agarwal and Naik, 2000, ‘On taking the ‘Alternative’ Route: Risks, rewards, and performance persistence of hedge funds,’ Journal of Alternative Investments 2(4), 6–23.

Ackermann, McEnally, and Ravenscraft, 1999, ‘The performance of hedge funds: Risk, return, and incentives.” Journal of Finance 54, 833–874.

Fung, Hsieh, Naik, and Ramadorai, 2008, ‘Hedge Funds: Performance, risk and capital formation,’ Journal of Finance 63, 1777–1803.

22

Documents

Lecture8 Arbitrage Slides