occurs when a company decides to acquire another company. Shareholders
of the acquired company receive cash in exchange for their shares. In ex-
change offers and mergers, shareholders of the acquired company receive
shares in the acquiring company in exchange for their shares. Sometimes, in
the case of mergers and tender offers, the acquired company shares are ex-
changed for a combination of cash and shares. In all of these situations the
commonality lies in the fact that they involve an exchange of one security for
another on a scheduled date in the future. Trading on the price disparity be-
tween the two exchanged securities is termed risk arbitrage.
How does pairs trading figure in all of this? The answer is quite straight-
forward. Of the two securities involved in the exchange, we buy the lower-
priced security, sell the higher-priced security, and lock in the price
difference for our profit. Note that this is possible only when both the secu-
rities in question are traded currently in the open market. In the case of re-
capitalizations and spinoffs, one side of the exchanged securities is issued
afresh and cannot be traded before issue. Keeping with the theme of pairs
trading, we therefore focus on mergers and exchange offers.^1
History
Risk arbitrage in America is more than 100 years old. In the 1890s, there
was a five-year depression and about one quarter of the railroad industry
faced bankruptcy and was reorganized. In the reorganization, old debt was
exchanged for new debt plus equity consisting of both preferred and com-
mon stock. The new securities often represented more value than the old
ones. As a result, arbitrageurs could buy the debt and sell the new securities
after a time for a profit.
Another occasion conducive for the practice of risk arbitrage was when
the large processing industry trusts were converted to corporations. Trusts
were vehicles for interstate commercial activity when holding companies
were not permitted by state law. Subsequently, the New Jersey Holding
Company Act permitted the trusts to be reorganized. In these reorganiza-
tions, arbitrageurs could buy trust certificates in the market and exchange
them for new preferred and common stock that the market bid at a pre-
140 RISK ARBITRAGE PAIRS
(^1) Quite a large percentage of risk arbitrage practitioners focus primarily on mergers
and acquisitions. Some of the practitioners trading around recapitalizations and
bankruptcies call their practice distressed security investing, or, more colorfully, as
vulture investing. It is also true that the two differ significantly in their method of se-
curity analysis, not to mention the even greater difference in the legal aspects sur-
rounding them. We are thus here in this murky area of nomenclature, and what
exactly falls under the umbrella of risk arbitrage could be debated.