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+446 Part IV: Additional Considerations 
+Example: XYZ, which is selling for $50 per share, offers to buy out LMN and is offer­
+ing to swap one share of its (XYZ's) stock for every two shares of LMN. This would 
+mean that LMN should be worth $25 per share if the acquisition goes through as pro­
+posed. On the day the takeover is proposed, LMN stock would probably rise to about 
+$22 per share. It would not trade all the way up to 25 until the takeover was approved 
+by the shareholders of LMN stock. The arbitrageur who feels that this takeover will 
+be approved can take action. He would sell short XYZ and, for every share that he is 
+short, he would buy 2 shares of LMN stock. If the merger goes through, he will prof­
+it. The reason that he shorts XYZ as well as buying LMN is to protect himself in case 
+the market price of XYZ drops before the acquisition is approved. In essence, he has 
+sold XYZ and also bought the equivalent of XYZ (two shares of LMN will be equal to 
+one share of XYZ if the takeover goes through). This, then, is clearly an arbitrage. 
+However, it is a risk arbitrage because, if the stockholders of LMN reject the offer, 
+he will surely lose money. His profit potential is equal to the remaining differential 
+between the current market price of LMN (22) and the takeover price (25). If the 
+proposed acquisition goes through, the differential disappears, and the arbitrageur 
+has his profit. 
+The greatest risk in a merger is that it is canceled. If that happens, stock being 
+acquired (LMN) will fall in price, returning to its pre-takeover levels. In addition, the 
+acquiring stock (XYZ) will probably rise. Thus, the risk arbitrageur can lose money 
+on both sides of his trade. If either or both of the stocks involved in the proposed 
+takeover have options, the arbitrageur may be able to work options into his strategy. 
+In merger situations, since large moves can occur in both stocks ( they move in 
+concert), option purchases are the preferable option strategy. If the acquiring com­
+pany (XYZ) has in-the-money puts, then the purchase of those puts may be used 
+instead of selling XYZ short. The advantage is that if XYZ rallies dramatically during 
+the time it takes for the merger to take effect, then the arbitrageur's profits will be 
+increased. 
+Example: As above, assume that XYZ is at 50 and is acquiring LMN in a 2-for-l stock 
+deal. LMN is at 22. Suppose that XYZ rallies to 60 by the time the deal closes. This 
+would pull LMN up to a price of 30. If one had been short 100 XYZ at 50 and long 
+200 LMN at 22, then his profit would be $600 - a $1,600 gain on the 200 long LMN 
+minus a $1,000 loss on the XYZ short sale. 
+Compare that result to a similar strategy substituting a long put for the short 
+XYZ stock. Assume that he buys 200 LMN as before, but now buys an XYZ put. If 
+one could buy an XYZ July 55 put with little time premium, say at 5½ points, then 
+he would have nearly the same dollars of profit if the merger should go through with 
+XYZ below 55.