Investing in the Options of Takeover Target Firms
The large abnormal returns available to the common shareholders of takeover target firms has received considerable attention in the financial literature. Jensen and Ruback  review previous studies and report an average abnormal return of 29.1 percent to the target firm shareholders in the months surrounding a merger announcement. But these results do not imply that an investor who does not possess inside information and does not own shares of the target firm prior to the first public announcement can transact after the first announcement of a proposed merger and attain any abnormal returns. In fact, several event studies [1,2,5,7,11] provide evidence that an investor cannot earn abnormal returns in the post-announcement period if he does not have foreknowledge of the eventual outcome of the proposed merger. The abnormal daily returns obtained in these studies either occur on or before the first public announcement or only accrue to the shareholders of target firms that were ultimately acquired; the post-announcement abnormal returns to the shareholders of target firms that were not ultimately acquired were negative.
This study examines whether an investor who purchases the call options on the underlying common stocks of takeover target firms could earn abnormal returns net of commissions. Abnormal returns may be available on the options of takeover target firms even if abnormal returns are not available on the common stocks of these firms. Reilly and Gustavson , for example, found abnormal returns available on the call options of firms announcing stock splits even though no such profits were available on the common stocks of these firms. While Reilly and Gustavson  do not empirically identify the sources of any inefficiencies, they reason that abnormal returns on the options may be caused by (1) the increased leverage of options returns and/or (2) any increase in the volatility of the underlying common stock returns caused by the announcement (call option prices are positively related to the volatility of the underlying common stock).
In this study, investment tests are designed where the investor purchases the call options of the takeover target firms at the closing price on the day the announcement first appears in The Wall Street Journal, day t = 0. These tests are also repeated assuming purchase is made on the day of the actual announcement, day t = -1. The investor transacts only on the basis of the news in the first public announcement in The Wall Street Journal. This investor has no inside information or foreknowledge as to whether the merger will ultimately be successful or not; therefore, he may not know the final terms of any final consummated merger with respect to the type of merger, form of payment, and the degree of resistance of the target firm's management. Thus, all types of proposed merger announcements are included regardless of the initial terms or final outcome of the merger. Each of the investment tests is also performed on the common stocks of the takeover target firms.
SAMPLE AND METHODOLOGY
The sample includes 86 firms with exchange-listed options that were takeover targets during the period September 15, 1983, to August 31, 1988. Firms that were takeover targets via tender offers, direct proposals to management, and leveraged buyouts were considered. Both friendly and hostile, solicited and unsolicited takeover attempts were included without regard to the type of payment.
The target firms and their respective announcement dates were identified by reviewing the "Business and Finance" column on the first page of The Wall Street Journal for each date in the sample period. The Wall Street Journal Index was then reviewed for each firm to verify that no previous takeover announcements were made in the previous twelve months. The announcement in The Wall Street Journal did not include only formal (or confirmed) announcements by the immediate companies involved. …