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