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