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Current time:0:00Total duration:5:01

Video transcript

let's say there's some company a here and let's think about what its stock might be doing let's say this is just over the course of the day let's say it's stock is just trading right over here so as we go through the day its price and naturally changes but then right over here let's say this is within the day maybe this is happening at 10:00 a.m. 10:00 a.m. Eastern Time an announcement comes out an announcement comes out that be intends intends to acquire to acquire a at I don't know let's say that right now a is let's say that right now a is trading at $5 this year but a press release comes out that B intends to acquire a at $10 a share and let me write this down at $10 per share so you can imagine and they say they're going to do it with cash and we'll talk in future videos about how it becomes a little bit more involved they're going to be doing it with their own shares but they intend to do it with cash so if they're able to acquire a everyone who owns a share of company a will get $10 for it and those shares will go to Company B Company B will own company a all of a sudden so what do you think would happen to the stock of Company A we know that B intends to buy it for $10 a share well you can imagine if everyone thought that this is definitely going to happen that anyone who holds the stock is going to get $10 you could imagine that the stock would just gap up immediately to something close to $10 a share something close to $10 a share and then not even trade much around it because they know what they're going to get for it so this is if you knew that this merger or this acquisition was going to happen the reality is is that you don't always know just from this press release that B definitely will acquire a maybe they have to get approval from government bodies to make sure that they aren't getting a monopoly here maybe they still have to get the funding from some bank they still have to get a loan in order to be able to do this deal so there's some what maybe something else happens maybe there's another bidder who wants to require a and they're willing to pay more so you don't know exactly actly what's going to happen in this situation so you don't know for sure this is going to happen so what does normally happen is that instead of going all the way up it goes someplace in between so the reality sort of jumping from five to ten dollars it might jump from I don't know five to eight dollars and maybe it trades around here you might say well why does it trade at eight dollars and it would trade at eight dollars so notice if there was a hundred percent chance it would trade all the way to ten dollars right because that's what a stock a would be worth now cuz B's going to pay that but if it trades at eight dollars essentially the market is saying essentially the market is saying that we're gonna give you three fifths right from five to eight is three dollars so it's giving you three fifths of the total jump that it could have if it was a hundred percent chance or another way to say it is that the market is saying that there is a 60% there is a 60% chance that this merger will go through anyone who thinks that there's more than a 60% chance if they do this over a bunch of security so that all the probabilities kind of work out eventually they should buy this security because they could by date and they think there's a it really should be worth ten anything whoo anyone who thinks that no way that this this acquisition is going to happen that they be isn't going to get the financing where the regulatory authorities aren't going to allow B to do this then they should short the stock when it goes up here because if the acquisition falls through then the stock is going to go back down here it's gonna go back down to the five dollar range before the announcement and so people and especially hedge funds who act in this way based on they are thinking that the merger is more likely to occur or less likely occur based on their research or maybe they have some quantitative models or maybe they have some information other people don't have that might be legal or might be otherwise they would place these bets the people who think that the merger will happen will by expecting it to go to ten dollars the people who think it won't they will short expecting it to go to five dollars and this strategy of playing the probabilities of a merger happening this is called merger arbitrage merger ARB sometimes called for short merger arbitrage it's Arbor because someone who who feels like they know the merger is going to happen they can buy something for eight and then sell or they could buy something for eight that is going to be worth ten dollars they can sell it for ten at some future date when B acquires the company or if they know the merger isn't going to happen they can short it for eight and then buy it back for five dollars once again make kind of doing an arbitrage on on a price differential they think something that's worth five is trading at eight on the downside and on the upside they think something that's trading at eight is worth ten