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.