What is Risk Arbitrage?

James Withers

Risk arbitrage is typically used to refer to a securities investment that is aimed at exploiting the vulnerabilities of a target firm prior to its acquisition by the acquiring firm. This type of arbitrage may also refer to the practice of purchasing stock in a company solely for the purpose of reaping a financial benefit should the assets of the company be liquidated. While practitioners of risk arbitrage engage in calculated investment risks, this investment strategy assumes that a number of variables are likely to influence the fortunes of a tarted company. Obviously, whether the investors realize significant returns or significant losses will depend on whether their predictions come to fruition.

Man climbing a rope
Man climbing a rope

As with other forms of arbitrage, information and speed of action are important components to a successful outcome. Arbitrageurs must be alert to changing market conditions, and must make investments during optimal windows of opportunity which are oftentimes short-lived. Additionally, they may desire to take advantage of these opportunities before competing investors are able to act on them.

One of the most popular forms of risk arbitrage is merger arbitrage. Investors in this type of trading are chiefly concerned with whether the merger of two corporations or entities will be approved, and how long this approval will take to be formalized. Due to the uncertainty as to whether a merger will be successful, a target company's stock will usually sell at an attractive price prior to the proposed merger. Thus, investors are posed with a potential earnings opportunity should the merger occur, after which the stock will increase in value. Arbitrageurs can reduce their investment risk by studying the histories of the companies involved in the proposed merger, and by identifying common trading trends related to such a merger.

A similar type of arbitrage is pairs trading. Investments of this sort are made on the basis of identifiable correlations between the market activities of similar companies or products. If the stock prices of two companies rise and fall in similar ways, investors will wait for the price of one of the companies to decrease from that of the other. Eventually, the prices are likely to express a renewed correlation. Thus, an investor gambles that the value of a low-priced stock will rise once again to match that of the comparable higher-priced stock.

While risk arbitrage itself is not illegal, investors who practice this form of securities trading may become subject to investigation by the the Securities and Exchange Commission (SEC) if the information they use to inform their investments is believed to be unavailable to the general public. In the US, and many other countries, trading that is made on the basis of non-public information culled from inside sources is illegal and is subject to criminal prosecution. Thus, while this method of investing bears financial risk, it may also bear a legal risk if it is not practiced with careful attention to the law.

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