Main content
Finance and capital markets
Course: Finance and capital markets > Unit 6
Lesson 7: Mergers and acquisitionsSimple merger arbitrage with share acquisition
Showing how a merger arbitrage player might act if they were sure that a transaction would go through. Created by Sal Khan.
Want to join the conversation?
Inside trading is mentioned a lot. What are the guidelines for someone using inside trading. Are say higher ranked company's employees not allowed to trade their own stock when they know it will go up?(9 votes)
Anyone - employee or not - is not supposed to profit from material non-public information that can affect the price of a stock. So if you work for a Hedge fund (perhaps one named after a ship used to transport gold by spain) and you find out that an acquisition is going to be announced because you golfed with the CFO. If you make a large purchase and profit, and the SEC finds out that you knew, you could be prosecuted. However, if you just think that the acquisition is likely because it would be a good strategic fit, and you didn't know the CFO, you could have made the purchase and profited as well. That's why the cases are hard to prove sometimes.(23 votes)
Could you explain, pleace, why shorting A's shares? Will it be done if there are assumptions that A's share price will fall?(4 votes)
it is a risk free position but also no upside..
if A goes up to 40 then 2 A shares will be worth 80. you shorted them for 60, so you lost 20. BUT! you bought B for 55 and will now receive 80 (+25). So you always end up with +5.
Same counts for A going down.
A to 20. 2 A shares then 40. You make a profit on a of +20 (when selling it back for 30).
You will make a loss of 15 on B, since you bought them for. Your total profit again +5. always(11 votes)
how is one supposed to know all these details about the merger. Do companies announce them??(3 votes)
The companies first announce their intentions to merge and for what price. However, before a merger can actually take place, there are a lot of things that it needs to go through first. For instance, the SEC will want to make sure that the two companies do not have any overlapping markets, for fear that they might create a monopoly. If you are an insider, and so can know what the SEC will decide, you have the advantage here. Of course, eventually the company will just announce everything.(6 votes)
- This arbitrage looks really risky if the deal doesn't go through. Usually when the news of acquisition is announced, the company being acquired (B) will immediately be traded at a premium whereas the acquiring company (A) will be at a discount. If you place your arbitrage now after the acquisition news betting that B will go up even further to match 2x the price of A, and then months later, when it becomes increasingly clear that A cannot follow through with the acquisition, A's price will rise and B's price will drop, making you suffer on both the long and the short positions. I'm purely doing a thought experiment here. Anyone with actual experience care to share their opinion on this?(3 votes)
- Yes, you lose money if the deal doesn't go through, and you make money if it does. The job of the arbitrageur is to determine when the price gap is big enough to justify the risk.(1 vote)
If 2 companies were rivals, and A bought a majority (51%) of B's stock, does that mean they could force an actual merger?(3 votes)
no antitrust regulators would have to clear the merger and plus it's unlikely that a rival company could acquire 51% just like that.(1 vote)
What would be needed or required for an individual to be able to make this sort of trades? For example someone who doesn't have all the resources and money that a hedge fund does. Thanks.(2 votes)
Actually, all you need is an Interactive Brokers account. The fees are low enough and margin is available to make this strategy a profiatble endeavor. Also you can use this spreadsheet to help with pricing merger arbitrage spreads when dividends are involved.
https://mergerarbitragelimited.com/arbitrage-spread-calculator/(1 vote)
How can we assume that one share of B is worth twice the value of a share of A.(1 vote)- One share of B isn't worth two shares of A, until the companies agree to merge. The equality appears from the fact that company A will end up giving two shares of A for one share of B.(3 votes)
I have a final doubt in my head after this video. After the acquisition, will B not exist any more, or will both the companies exist? Thanks(1 vote)- after an acquisition, the stock of the acquired company is gone.(2 votes)
- What would happen to stock B after acquisition if stock A is trading higher than B, lets say $80 per share?(1 vote)
Say you had a position open on an online brokerage that traded CFD's, then you bought shares of JC Penny for example. What would happen to your position if JC Penny is acquired by another company? when you're not up-to date when the transaction is taking place. Is your position just closed for you automatically at the latest price?(1 vote)- Yes, your broker will settle the option contract on your behalf.(1 vote)
Video transcript
In the last couple of videos
we set a scenario where company A intends to acquire company B. Their going to do it by
issuing 2 million shares and then giving those
2 million shares to the shareholders of company B, and company B shareholders will give,
essentially, all of their ownership away. Their will
be an exchange 2 million of company A shares for 1
million of company B shares. On a [per search 0:24] share
basis the owners of company B will give up one of their
shares, and in exchange they will get 2 shares of company A. They will get 2 shares in company. We saw that if everyone
thought that this transaction was going to happen,
theoretically, whatever A is trading at B should
trade at twice that. People know that they'll
always be a little trade-in, or when the transaction
happens there be a little trade-in of B for two of these A shares. What happens is a
situation, or why would a situation happen where B
doesn't trade at twice of A? This is a theoretical trading twice is A. This is 2 times A. What happens if it doesn't trade there? What happens if B's shares are trading ... let me do this in a color
I haven't used before. What if it's trading a
little bit lower there? Well, that might be the
case, because some people don't think that the
transactions going to happen. Their not willing to pay that full premium for B. Let's say that this were to happen, and you are working at
some type of a hedge fund that has some type of model,
maybe some mathematical model, maybe you have some
type of shady information. Where you know for a fact,
you are 100% certain, this transaction is going
to close. It's definitely going to close with these
terms. 2 million shares of A in exchange for
1 million shares of B. Your temptation might be,
well, why don't I just buy these shares of B,
because they will go up. What if the whole market goes down? What if the stock of
A goes down like this? Then 2 times A will also go down. You don't want to just buy
the stock of B thinking it's going to go up. If
the transaction is really going to happen, B is just
going to track 2 times the price of A. The best way to do it is
to really set up a bit of a pair trade here. What
you would do is if you think the transaction
is definitely happening, you could buy 1 share ...
let me write this down. You could buy 1 share of B. Share of B. You've gone long 1 share
of B. Then you can short 2 shares of A. The reason
why this will work, and this will only work if you know the transaction is going to happen, is because right now 2 shares of
A are going to be ... at any point since B is trading
a little bit of a discount to that, the 2 shares of
A are going to be worth more than that the 1 share of B. When you sort 2 shares
of A, maybe, where this point right here ...
let's say that we are at this point on that day that everything was announced. When you short
2 shares of A, you're going to get $60. You're going to get $60. This is a review. You borrow the stock,
you sell it, and you're going have to buy it
back at some future date. You owe someone 2 shares
of A. When you buy 1 share of B, it's not
going to be trading at $60, it's going to be trading at some discount. Let's say that that cost
you $55. It's trading a little bit of discount to 2 times A. Clearly just here, you have netted. $60 minus $55, you have netted $5. $5 net. Then assuming
the transaction happens at some future date, when
the transaction closes, that 1 share of B that
you had, you can exchange it for 2 shares of A. You get 2 times A. Then you could use that
to cover your short position. You use that to cover your short position, and you're
left standing with $5. You essentially made ...
well, there is a risk that the transaction
didn't close, but assuming the transaction happened,
this was kind of a [pedima 04:17] free $5 for your taking.