Merger arbitrage is an investment technique in which an someone invests trades the stocks of companies involved in a possible merger. The strategy aims to take advantages of the price discrepancies of the companies before and after the merger. An investor practicing merger arbitrage will buy shares of a company about to be acquired in a merger that expects a price boost when the it goes through. This investor will often also sell shares of the acquiring company in hopes of a price drop for that company and also as a hedge against the merger failing.
Arbitrage refers to the practice of buying stocks with the intent of immediately reselling them at a higher price. In the case of merger arbitrage, this takes place when rumors of a merger between two companies begin to circulate. The person who makes the trade, also known as an arbitrageur, believes that an impending merger represents an ideal time to pounce on a rare inefficiency in the market.
When a merger is looming, an arbitrageur will focus on going long on the company about to be acquired, which means that he or she will buy its shares. This transaction is usually accompanied by the arbitrageur short-selling shares of the acquiring company. At some later point, the arbitrageur will likely buy these shares back, ideally at a much lower price than at what they were sold.
The larger the difference between the current price of the target company and the price at which they will eventually be purchased in the merger, the better the transaction will turn out for the arbitrageur. Merger arbitrage also benefits from the sometimes extended time between the time the merger is announced and the deal actually going through, allowing for the benefits of the price discrepancy to multiply for the investor over that time. If that occurs, and the acquiring company's stock falls in accordance with the acquired company's stock rising to the purchase price once the merger is finalized, then the arbitrageur has a chance at a significant profit.
There are several dangers that make merger arbitrage a risky maneuver. The most damaging is when a merger fails to go through, which can result in the stock of the company that was supposed to be acquired drop. Another possibly damaging situation is a bear market, which could cause stocks to drop despite the impending merger. That's another reason why the short-selling of the acquiring company is important, as it acts as a hedge in situations when both companies' prices move in the same direction.