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Hedge fund strategies: Merger arbitrage 1

Simple case of merger arbitrage when there is an all cash acquisition. Created by Sal Khan.

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 its stock is just trading right over here. So as we go through the day, it's price naturally changes. But then right over here-- let's say this is within the day, maybe this is happening at 10AM Eastern Time-- an announcement comes out that B intends to acquire A. I don't know, let's say that right now A is trading at $5 a share, but a press release comes out that B intends to acquire A at $10 a 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 if 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 could 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. 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. Maybe something else happens. Maybe there's another bidder who wants to acquire A and they're willing to pay more. So you don't know exactly 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, instead of jumping from $5 to $10, it might jump from, I don't know, $5 to $8, and maybe it trades around here. You might say, well, why does it trade at $8? And it would trade at $8-- so notice, if there was 100% chance it would trade all the way to $10, right, because that's what stock A would be worth now, because B is going to pay that. But if it trades at $8 essentially the market is saying that we're going to give you 3/5. From $5 to $8 is $3. So it's giving you 3/5 of the total jump that it could have if it was 100% chance. Or another way to say it is, is that the market is saying that there is a 60% percent 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 securities, so that all the probabilities kind of work out eventually-- they should buy this security. Because they could buy at $8, and they think it really should be worth $10. Anyone who thinks that, no way that this acquisition is going to happen, B isn't going to get the financing or 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 going to go back down to the $5 range before the announcement. And so people, and especially hedge funds, who act in this way based on their thinking that the merger is more likely to occur or less likely to 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 buy expecting it to go to $10. The people who think it won't, they will short, expecting it to go to $5. And this strategy of playing the probabilities of a merger happening, this is called merger arbitrage. Merger arb, sometimes called for short. And it's arbitrage because someone who feels like they know the merger is going to happen, they can buy something for $8 and then sell. Or they could buy something for $8 that is going to be worth $10. They can sell it for $10 at some future date when B acquires a company. Or, if they know the merger isn't going to happen, they can short it for $8 and then buy it back for $5. Once again, kind of doing an arbitrage on a price differential. They think something that's worth $5 is trading at $8 on the down side. On the upside, they think something that's trading at $8 is worth $10.