Academic journal article Quarterly Journal of Finance and Accounting

Is Risk Arbitrage Market Neutral: The Case of Stock Swap Offers with Collars

Academic journal article Quarterly Journal of Finance and Accounting

Is Risk Arbitrage Market Neutral: The Case of Stock Swap Offers with Collars

Article excerpt

Introduction

Risk arbitrage strategies are designed to profit from the positive spread between the offer and the target firm's stock price that often remains after a takeover attempt announcement. The appropriate risk arbitrage positions are closely linked to the structure of the deal's consideration. In a cash or fixed value stock swap offer, arbitrageurs only need to purchase and hold the target's stock until deal completion. In a fixed exchange ratio stock swap offer, arbitrageurs purchase and then hedge the target's stock by shorting a shares of the bidder's stock, where a represents the exchange ratio specified in the merger agreement at the time of the announcement.

Considerable attention has been given to exploring the risk and return characteristics of risk arbitrage. That literature is almost unanimous in concluding that risk arbitrage tends to generate positive risk-adjusted returns (Larker and Lys 1987; Dukes, Frohlich and Ma 1992; Karolyi and Shannon 1999; Mitchell and Pulvino 2001; Baker and Savasoglu 2002). Studies like Mitchell and Pulvino (2001) have also shown that risk arbitrage portfolios are correlated with the market returns in a nonlinear way: positive in a declining market but essentially zero in a flat or appreciating market. That deals are more likely to fail in a declining market and thereby result in losses for risk arbitrageurs probably accounts for this nonlinearity. In other words, risk arbitrage is not as market neutral as some claim. Previous results have, however, been derived from samples, which only include cash and simple stock swap offers (fixed value stock swap offers and fixed ratio stock swap offers). They do not include an analysis of stock swap offers that contain what are called "collars." With a collar structure, the exchange ratio is not fixed at the deal announcement. Rather, it depends on the bidder's stock price over a period near deal's closing date. The two major types of collar offers are fixed value and fixed exchange ratio collar offers. Collars are designed to protect the target and the bidder from adverse moves in the bidder's stock price. About 20% of stock swap mergers contain collars (Officer 2006).

It is interesting to explore the risk return characteristics for risk arbitrage on stock swap offers with collars. First of all, is there a downside market risk in risk arbitrage involving collar offers? Intuitively, the collar structure being more flexible should reduce the need for renegotiation when the bidder and the target prices change dramatically during the bid process and, thus, allow some deals to survive that would not if they had to be renegotiated. Therefore, collar offers may not be more likely to fail in a down market. However, there is an adverse selection as well. Deals that have a higher risk of not going through may be structured as collars in order to provide some flexibility that is designed to improve their chances of dealing with the unexpected. In fact, the literature has documented certain features associated with the bidders/targets involved in collar offers (e.g., different industry membership, greater difference in market risk exposure, less correlation). Those features all have influences on the outcome of a deal. Some have negative influence on the chance that a deal will succeed, while some have positive influence. Due to those reasons, it's not clear whether collar offers have a higher probability to fail in a declining market. In other words, the nonlinear relationship between the arbitrage returns with the market returns for stock swap offers and cash offers may not hold for collar offers. In addition, hedging risk arbitrage positions involving collar offers is more difficult than is hedging the other types of offers. Specifically, option type dynamic delta hedging, which is likely to increase the associated transactions costs, may be required. Is such strategy profitable on a post- transaction cost basis?

Herein we explore these questions. …

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