What are the risks associated with arbitration?

In the media or the news, there are always reports about the merger or purchase of a company by another rival company. Mergers and acquisitions are an integral part of a company’s business cycle. In their quest for sustainability, many companies merge with other companies to ensure business synergy and that they can use the other company’s resources and customer base to grow. Apart from mergers, companies acquire different companies that are not performing well and have been showing consistent losses for several years. These companies are the ones that were once doing good business but have slid into losses due to the unexpected or mismanagement.

Large corporations are always looking for merger or acquisition of a business to push their business towards better profitability. The scout for those companies that are not doing well right now but have huge potential if given the resources. They make an offer to buy the companies, and if accepted, the merger or acquisition is successful.

When they enter the financial market to make profit, the news of a merger or acquisition is in the interest of the investor and they execute many strategies to use the price movement to make profit. Among the different strategies, Risk Arbitrage is the most widely used. But before understanding risk arbitrage trading, you must know the concept of arbitrage.

What is Arbitration?

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

Arbitrage is the simultaneous buying and selling of any of the securities, such as stocks, commodities, bonds, currencies, etc., in different markets to take advantage of the price difference. These investors, called arbitrageurs, look for the price difference and buy the security in one market at a lower price and resell 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 capital markets. This strategy involves buying stocks that are in the process of being merged or acquired, or merged. Merger arbitrage is popular among hedge funds with a higher risk appetite. They buy the shares of the target company and short sell the shares of the acquirer. These strategies are normally operated using futures contracts with company shares as the underlying asset.

This form of arbitrage is an event-driven trading strategy that speculates on whether the stock prices of the acquirer and the acquiring company will rise or fall. If investors think they will go up or down, they execute the risk arbitrage strategy to benefit from the price movement. Since the price of the acquiring company may rise after the announcement of the acquisition, investors take a long position in the stock. However, since they believe the shares of the acquiring company may fall at the same time, they simultaneously take a short position in the stock to create a hedge.

How does risk arbitrage work?

Risk Arbitrage is one of the most complex stock market strategies used by professional investors to profit from a merger or acquisition. To understand how risk arbitrage works, you might consider reading the following detailed example:

Suppose the shares of a company XYZ are trading at Rs 500. After the close of trading, another company, ABC, placed an open bid to buy XYZ at a premium of 20% or Rs 600 per share. This news instantly becomes public and reaches investors who believe that the positive news will boost XYZ stock price in the next trading session. The price may go up to Rs 600 as investors believe this to be the fair value of the company’s shares, otherwise ABC would not have made the offer at this price.

However, acquisitions are always at risk of not proceeding due to legal obligations, audit reasons, economic developments, regulatory challenges, etc. Uncertainty forces XYZ shares to oscillate near the Rs 600 level. For example, it may be trading at Rs 530, Rs 550, Rs 570, etc. The closer the XYZ share price is to Rs 600, the more likely it is that the takeover deal will succeed.

Order 1: The long position

Based on the speculation that the price of XYZ Company 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 operation is successful. The transaction will earn the investor a profit of Rs 7,000 (Rs 60,000-53,000)

Now, since the investor has placed a long position in the shares of XYZ, the next trade is to short the shares of ABC. Indeed, as ABC will bear the cost of acquiring XYZ, its stock price could decline due to the huge expense. Suppose ABC is trading at Rs 1,500 and the investor expects its share price to fall to Rs 1,200. The investor will place a short call.

Order 2: The short position

Based on the speculation that the price of ABC Company may drop from Rs 1,500 to Rs 1,200, an investor places a short order to buy 100 ABC shares as soon as the market opens. If the order is executed at Rs 1,450, the investor can wait for the price to drop to Rs 1,200 or when the acquisition operation 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 in the stock market works and allows investors to make profits by placing a long position and a short position simultaneously

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What are the risks involved in Risk Arbitrage?/h2>

As the risk arbitrage strategy is one of the most difficult to execute, it carries the following risks for the hedge fund or the investor:

  • Tracking Difficulty: Developments regarding mergers and acquisitions are difficult to follow because they happen instantly and without notice. Also, if followed, there is no guarantee that the news is reliable. As this may turn out to be wrong, investors who have taken long and short positions in risk arbitrage may end up losing their investments and suffering huge losses.
  • Trading risk: Transaction risk is the risk that an investor takes in the event that the acquisition transaction does not go through. If unsuccessful, this can negatively impact the company’s prices, causing the investor to lose a large sum of money.
  • Price drop : As investors only speculate that the share price of the acquiring company might rise, it may fall to very low levels. In such a case, investors may lose money on their long positions.
  • Uncertain chronology: Engaging in risk arbitrage only after the announcement of the acquisition or merger is risky because you can never know how long it will take for the deal to close. This can take months, allowing traders to enter equity derivatives 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 for taking advantage of these trades and earning considerable profits in the process. However, since the strategy is complex to execute and carries many potential risks, it is also a good idea 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 many trades that occur daily. For more information on risk arbitrage, visit the IIFL website or download the IIFL Markets app from the App Store.

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