Question

On November 30, 2019 (at 7AM), Firm A and Firm B announced a merger agreement noting that:

• The merger was expected to be completed by June 2020; and

• 5.5 shares of Firm A’s stock were expected to be paid for each share of Firm B’s stock (i.e., each share of Firm B can be swapped for 5.5 shares of Firm A if the merger is completed).

        

On November 30, 2019 (at 4PM):

• Firm A’s stock closed at $20 per share; and

• Firm B’s stock closed at $85 per share.

Identify a risk arbitrage opportunity arising from the merger agreement announcement. You need to note:

• Which stock and the amount of shares (if any) that you are buying;

• Which stock and the amount of shares (if any) that you are short-selling; and

• The profit arising from the risk arbitrage opportunity.

Answer 1

Swap Ratio defined as per merger agreement is 5.5 shares of Co A for 1 share of Co. B

Hence in order to have no arbitrage opportunity,

5.5 Shares of Company A should be equal to 1 share of Company B

i.e 5.5 * 20 = 110 (Co A)

As we observe Co B share is 85 which is lower than 5.5 shares of Co A, arbitrage opportunity exists

To take arbitrage advantage:

As we cannot sell 5.5 odd number of Co A shares, we take next multiple of 11 shares of Co A and 2 shares of Co B

1. We buy 2 shares of Co B and we pay 85 * 2 = 170

2. We sell 11 shares of Co A and we receive 11*20 = 220

3. Net Inflows = 220 - 170 = 50 profit on every 2 shares of Co B