Todd C. Pulvino

Characteristics of Risk and Return in Risk Arbitrage

This paper analyzes 4,750 mergers from 1963 to 1998 to characterize the risk and return in risk arbitrage. Results indicate that risk arbitrage returns are positively correlated with market returns in severely depreciating markets but uncorrelated with market returns in f lat and appreciating markets. This suggests that returns to risk arbitrage are similar to those obtained from selling uncovered index put options. Using a contingent claims analysis that controls for the nonlinear relationship with market returns, and after controlling for transaction costs, we find that risk arbitrage generates excess returns of four percent per year. AFTER THE ANNOUNCEMENT OF A MERGER or acquisition, the target company’s stock typically trades at a discount to the price offered by the acquiring company. The difference between the target’s stock price and the offer price is known as the arbitrage spread. Risk arbitrage, also called merger arbitrage, refers to an investment strategy that attempts to profit from this spread. If the merger is successful, the arbitrageur captures the arbitrage spread. However, if the merger fails, the arbitrageur incurs a loss, usually much greater than the profits obtained if the deal succeeds. In this paper, we provide estimates of the returns to risk arbitrage investments, and we also describe the risks associated with these returns. Risk arbitrage commonly invokes images of extraordinary profits and incredible implosions. Numerous articles in the popular press detail large profits generated by famous arbitrageurs such as Ivan Boesky and even larger losses by hedge funds such as Long Term Capital Management. Overall, existing academic studies find that risk arbitrage generates substantial excess returns. For example, Dukes, Frohlich, and Ma ~1992! and Jindra and Walkling ~1999! focus on cash tender offers and document annual excess returns that far exceed 100 percent. Karolyi and Shannon ~1998! conclude * Harvard Business School and Kellogg School of Management, respectively. We are grateful to seminar participants at the Cornell Summer Finance Conference, Duke University, Harvard University, the University of Chicago, the University of Kansas, the New York Federal Reserve Bank, the University of North Carolina, Northwestern University, the University of Rochester, and the University of Wisconsin-Madison for helpful comments, and to three anonymous referees, Malcolm Baker, Bill Breen, Emil Dabora, Kent Daniel, Bob Korajczyk, Mitchell Petersen, Judy Posnikoff, Mark Seasholes, Andrei Shleifer, Erik Stafford, René Stulz, Vefa Tarhan, and especially Ravi Jagannathan for helpful discussions. We would also like to thank the many active arbitrageurs who have advanced our understanding of risk arbitrage. THE JOURNAL OF FINANCE • VOL. LVI, NO. 6 • DEC. 2001

Arbitrage crashes and the speed of capital

The imminent failure of prime brokers during the 2008 financial crisis caused a sudden decrease in the leverage afforded hedge funds. This decrease resulted from the asymmetrical payoff to rehypothecation lenders—the ultimate financiers, through prime brokers, to hedge funds. Seemingly long-term debt capital became short-term capital creating a duration mismatch between left-hand side arbitrage opportunities and right-hand side liabilities. Consequently, arbitrageurs became unable to maintain similar prices of similar assets. Mispricing magnitudes, and the time required to correct them, reflect the role of arbitrageurs in maintaining accurate prices during normal times and offer an estimate of discounts at which assets transact during crises.