Merger Arbitrage

Also known as risk arbitrage, a merger arbitrage trade consists of buying the stock of a company that is the target of a takeover while shorting the stock of the acquiring company. Normally the stock price of the target company is less than the price offered by the acquiring company. The spread between these two prices depends mainly on the probability and the timing of the takeover being completed as well as the prevailing level of interest rates. The spread often widens and narrows during the course of time between the merger announcement and merger closing. Arbitrageurs enter and exit the arbitrage trade either once or many times depending on the fluctuations of the spread. A merger arbitrage trade makes money when the spread narrows or when the deal closes. The risk , which gives this arbitrage trade its name, is that the deal falls through and the spread widens. Not all risk arbitrage trades result in a loss when a deal falls through. The return depends on what the long and short positions do.

Convertible Arbitrage

A convertible bond is a bond can be converted into a predetermined number of shares of the issuing company. A convertible bond can be thought of as a bond with a call option attached to it. A convertible bond's price is sensitive to three factors: - interest rate. When rates move higher, the bond part of a convertible bond tends to move lower, but the call option part of a convertible bond moves higher (overall price tends to move lower). - stock price. When the price of the stock the bond is convertible into moves higher, the price of the bond tends to rise. - credit spread. If the issuer's financial strength deteriorates and its credit spread widens, the bond price will move lower, but, in many cases, the call option part of the convertible bond moves higher (since credit spread correlates with volatility). The complexity of convertible bond arbitrage generally precludes individual traders from practicing this trading style. It is most often utilized by hedge funds and prop desks. The models for pricing these deals are difficult to create and rely upon complex mathematics to gauge the difference between the trading price and theoretical value of the convertible bonds. Convertible arbitrage generally consists of buying a convertible bond and hedging two of the three pricing factors in order to gain exposure to the third factor at an attractive price. For instance an arbitrageur would first buy a convertible bond, then sell fixed income securities or interest rate futures (to hedge the interest rate exposure) and buy some credit protection (to hedge the risk of credit deterioration). Eventually what he'd be left with is something similar to a call option on the underlying stock, acquired at a very low price. He could then make money either selling some of the more expensive options that are openly traded in the market or delta hedging his exposure to the underlying shares.