The arbitrageur may find the reward adequate but the risk too high. In such
situations, the arbitrageur can protect himself against a widening spread
through the use of options.
Typically, the target stock experiences higher volatility relative to the
bidder stock. The common strategy under these circumstances is to pur-
chase a put on the target stock, thus protecting against a steep drop in the
price of the target. While the price paid to enter into the hedge eats away at
some of the profit in the trades, the risk due to the put purchase is a lot
lower.
It may also be that the deal poses a high degree of risk for some time.
Once the event resolves itself favorably, the risk of deal break diminishes
substantially. The timing, strike, and expiration of the put used will there-
fore depend on the appetite for risk and the degree of risk aversion of the ar-
bitrageur.
It must therefore be noted that while at the surface the risk arbitrage
process seems cut and dried, there is still a substantial amount of decision
making and judgment calls that are left to the discretion of the arbitrageur.
SUMMARY
The risk neutral probability of merger is the probability implied by the
observed spread between the bidder and target firms.
It is similar to the implied volatility parameter for options.
The evolution of the risk neutral probability of merger can be related to
the spread dynamics.
It is useful in the design of more appropriate value at risk measures.FURTHER READING MATERIAL
Risk-Neutral Probability
Jarrow, R. and S. Turnbull Derivative Securities, (Cincinnati, Ohio: 2ndEdition.
South Western Publishing, 2000).
186 RISK ARBITRAGE PAIRS