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Course: Finance and capital markets > Unit 7
Lesson 4: Hedge fundsHedge fund strategies: Merger arbitrage 1
Simple case of merger arbitrage when there is an all cash acquisition. Created by Sal Khan.
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- Why on earth B would buy A for 10, when it could buy it at the current price, around 5?(14 votes)
- You can rarely ever buy an entire company for it's current market price. The market price represents the absolute minimum the owners of a company will demand for selling it all. Shareholders expect future cash flows and capital gains from owning shares and therefore need to be compensated in order to give those expected gains up. As a result, if you want to buy an entire company, you almost always pay more than the market price.(44 votes)
- Where and what kind of information would a hedge fund be able to discover about a merger that would tell them how to invest that wouldn't considered insider trading?(7 votes)
- In the case of meger arbitrage there are a number of moving parts in which hedge fund expertise could give them an edge. Knowledge of regulatory bodies (such as CFIUS) lending requirements for the bidder, management/employeee/union resistence and so forth. These would not necessirily be factors the original investors would need to condsider when making thier initial investment.
Therefore, following the initial post deal-announcement price rise these investors may wish to sell (and thus bank their profit) to the hedge funds who are capable of taking on the risk. ie making a small gain (arbitrage spread) against the risk that the deal does not consumate.
As the risks for a paricular stock change, so does the shareholder base.
Apologies for the brevity of this answer.(2 votes)
- Why would company B decide to publicly announce that they are going to acquire company A? Couldn't they just simply start buying up all the shares 1 by 1 and once they have it all they would completely own company A?(2 votes)
- Securities laws require announcements once purchases get over a certain side or when the intent of the purchases is to effect a change in control.(5 votes)
- Can someone help me understand the intuition of what happens to stock price during and after an acquisition?(3 votes)
- Why is this even called "arbitrage" when it has potential negative net cashflow, and therefore is not risk-free?(1 vote)
- It is arbitrage if you have insider knowledge that the hedge fund would have. Otherwise, it is not arbitrage.(3 votes)
- Why does the stock of Company A rise when Company B acquires A?(1 vote)
- The shares of company which is being acquired rises, shouldn't it be opposite? After merger they will become company A's share and it's rate will be determined by company A's current value of share. Why people would want to buy some share that will not exist in few days?(1 vote)
- Company B has promised to give $10 to anyone who owns a share. So, if you think there will be a merger, it is worth exactly $10.(1 vote)
- Could someone explain the 60% probability when it is at $8?(0 votes)
- At 100% probability, it would trade for the quoted purchase price of $10. Being that the price is currently $5, it will theoretically have a maximum price of $10. The delta between the current price of $5 and maximum price of $10 is $5. If it's only trading at $8, it is only up $3 out of a possible max of $5. 3/5 = .60 or 60%. Every dollar above $5 would represent 20%. Trading at $9 would mean an 80% probability.(1 vote)
Video transcript
Let's say there's
some company A here. And let's think about what
its stock might be doing. Let's say this is just
over the course of the day. Let's say its stock is just
trading right over here. So as we go through the day,
it's price naturally changes. But then right over here-- let's
say this is within the day, maybe this is happening
at 10AM Eastern Time-- an announcement comes
out that B intends to acquire A. I don't know, let's
say that right now A is trading at $5 a share,
but a press release comes out that B intends to
acquire A at $10 a share. So you can imagine--
And they say they're going to
do it with cash. And we'll talk in
future videos about how it becomes a little bit
more involved if they're going to be doing it
with their own shares, but they intend to
do it with cash. So if they're able to
acquire A, everyone who owns a share of company
A will get $10 for it, and those shares
will go to company B. Company B will own
company A all of a sudden. So what do you
think would happen to the stock of company A? We know that B intends to
buy it for $10 a share. Well, you could imagine
if everyone thought that this is definitely
going to happen, that anyone who holds the
stock is going to get $10. You could imagine that the stock
would just gap up immediately to something close
to $10 a share. And then not even
trade much around it, because they know what
they're going to get for it. So this is if you knew that
this merger or this acquisition was going to happen. The reality is, is
that you don't always know just from
this press release that B definitely
will acquire A. Maybe they have to get approval
from government bodies to make sure that they aren't
getting a monopoly here. Maybe they still have to get
the funding from some bank, they still have to
get a loan in order to be able to do this deal. Maybe something else happens. Maybe there's another bidder
who wants to acquire A and they're willing to pay more. So you don't know
exactly what's going to happen in this situation. So you don't know for sure
this is going to happen. So what does normally
happen is that instead of going all the way up, it
goes someplace in-between. So the reality, instead
of jumping from $5 to $10, it might jump from, I
don't know, $5 to $8, and maybe it trades around here. You might say, well,
why does it trade at $8? And it would trade
at $8-- so notice, if there was 100% chance it
would trade all the way to $10, right, because that's what
stock A would be worth now, because B is going to pay that. But if it trades at $8
essentially the market is saying that we're
going to give you 3/5. From $5 to $8 is $3. So it's giving you 3/5
of the total jump that it could have if it
was 100% chance. Or another way to say it
is, is that the market is saying that there
is a 60% percent chance that this
merger will go through. Anyone who thinks that
there's more than a 60% chance-- if they do this
over a bunch of securities, so that all the probabilities
kind of work out eventually-- they should buy this security. Because they could buy
at $8, and they think it really should be worth $10. Anyone who thinks that, no way
that this acquisition is going to happen, B isn't going
to get the financing or the regulatory
authorities aren't going to allow B to do this, then
they should short the stock when it goes up here. Because if the
acquisition falls through, then the stock is going
to go back down here. It's going to go back
down to the $5 range before the announcement. And so people, and
especially hedge funds, who act in this way
based on their thinking that the merger is
more likely to occur or less likely to occur--
based on their research, or maybe they have some
quantitative models, or maybe they have some
information other people don't have that might be legal
or might be otherwise-- they would place these bets. The people who think that
the merger will happen, will buy expecting
it to go to $10. The people who think it
won't, they will short, expecting it to go to $5. And this strategy of playing
the probabilities of a merger happening, this is
called merger arbitrage. Merger arb, sometimes
called for short. And it's arbitrage
because someone who feels like they know the
merger is going to happen, they can buy something
for $8 and then sell. Or they could buy
something for $8 that is going to be worth $10. They can sell it for
$10 at some future date when B acquires a company. Or, if they know the merger
isn't going to happen, they can short it for $8
and then buy it back for $5. Once again, kind of doing
an arbitrage on a price differential. They think something
that's worth $5 is trading at $8
on the down side. On the upside, they think
something that's trading at $8 is worth $10.