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Related to risk arbitrage: Merger arbitrage
Traditionally, the simultaneous purchase of stock in a company being acquired and the sale of stock of the acquirer. Modern risk arbitrage focuses on capturing the spreads between the market value of an announced takeover target and the eventual price at which the acquirer will buy the target's shares.
In hedge funds, an investment strategy related to mergers and acquisitions involving the purchase and/or shorting of an acquired company's stock. In a cash merger, the stock of the acquired company often trades below the offer price until the deal is completed. A hedge fund may buy at the lower price and wait for the deal to be completed, at which point it makes a profit. In a stock-for-stock merger, the acquiring company (with more valuable stock) offers to exchange the acquired company's stock for its own at a certain ratio. A hedge fund may then short sell the acquiring company's stock while simultaneously buying stock in the acquired company. When the deal goes through, the acquired company's stock is converted and the new stock returned to the owner from which the hedge fund borrowed. In both these situations, the primary risk is the possibility that the deal may fail in the middle of the hedge fund's transactions. See also: Exchange ratio.
The simultaneous purchase and sale of assets that are potentially, but not necessarily, equivalent. For example, Firm A may make an offer to acquire Firm B by exchanging one share of its own stock for two shares of Firm B's stock. If the stock of Firm A is trading at $50 and the stock of Firm B is trading at $23, the risk arbitrager would buy shares in Firm B and sell short one-half this number of shares in Firm A. If the buyout offer is approved, the two stocks will exchange on a one-for-two basis and the arbitrage position will be profitable. The risk is that the buyout will be unsuccessful and the exchange of stock will not take place. Risk arbitrage is also used in situations involving reorganizations and tender offers. Also called equity arbitrage.