450 Part IV: Additional Considerations 
Problems arise if XYZ begins to fall below 45 well before the closing of the 
merger, the lower "hook" in the merger. If it should remain below 45, then one 
should set up the arbitrage as being short 0.556 shares ofXYZ for each share of LMN 
that is held long. As long as XYZ remains below 45 until the merger closes, this is the 
proper ratio. However, if, after establishing that ratio, XYZ rallies back above 45, the 
arbitrageur can suffer damaging losses. XYZ may continue to rise in price, creating a 
loss on the short side. However, LMN will not follow it, because the merger is struc­
tured so that LMN is worth 25 unless XYZ rises too far. Thus, the long side stops fol­
lowing as the short side moves higher. 
On the other hand, no such problem exists if XYZ rises too far from its original 
price of 50, going above the upper "hook" of 55. In that case, the arbitrageur would 
already be long the LMN and would not yet have shorted XYZ, since the merger was 
not yet closing. LMN would merely follow XYZ higher after the latter had crossed 55. 
This is not an uncommon dilemma. Recall that it was shown that the acquiring 
stock will often fall in price immediately after a merger is announced. Thus, XYZ may 
fall close to, or below, the lower "hook." Some arbitrageurs attempt to hedge them­
selves by shorting a little XYZ as it begins to fall near 45 and then completing the 
short if it drops well below 45. The problem with handling the situation in this way 
is that one ends up with an inexact ratio. Essentially, he is forcing himself to predict 
the movements of XYZ. 
If the acquiring stock drops below the lower "hook," there may be an opportu­
nity to establish a hedge without these risks if that stock has listed options. The idea 
is to buy puts on the acquiring company, and for those puts to have a striking price 
nearly equal to the price of the lower "hook." The proper amount of the company 
being acquired (LMN) is then purchased to complete the arbitrage. If the acquiring 
company subsequently rallies back into the stated price range, the puts will not lose 
money past the striking price and the problems described in the preceding paragraph 
will have been overcome. 
Example: A merger is announced as described in the preceding example: XYZ is to 
acquire LMN at a stated value of $25 per share, with the stipulation that each share 
of LMN will be worth at least 0.455 shares of XYZ and at most 0.556 shares. These 
share ratios equate to prices of 45 and 55 on XYZ. 
Suppose that XYZ drops immediately in price after the merger is announced, 
and it falls to 40. Furthermore, suppose that the merger is expected to close some­
time during July and that there are XYZ August 45 puts trading at 5½. This repre­
sents only ½ point time value premium. The arbitrageur could then set up the arbi­
trage by buying 10,000 LMN and buying 56 of those puts. Smaller investors might 
buy 1,000 LMN and buy 6 puts. Either of these is in approximately the proper ratio 
of 1 LMN to 0.556 XYZ.