bands in technical analysis. Trading can be undertaken when the observed
spread is on the upper and lower fringes of the band.
We, however, add a note of caution. When the spread widens to the
upper fringe of the band, it may be because there is some deterioration in the
fundamentals of the merger and may not be just an aberration. Therefore,
one needs to exercise extreme caution when putting the spread on. The mat-
ter is straightforward when timing the unwind. If the observed spread is near
the bottom fringe of the band, then one can safely unwind the position and
get back into it again at a higher spread level.
Illustrated in Figure 12.3 is a plot of the spread, the Kalman smoother,
and the error bands. The bidder in this case was Alza Pharmaceuticals. The
target was Sequus Pharmaceuticals. The exchange ratio was 0.4 share. The
deal was announced October 5, 1998, and completed March 17, 1999.
Last, it is important to bear in mind that the smoothing scheme in Fig-
ure 12.3 has been set up with daily data in mind. When looking at data on
an intraday basis, there is likelihood of running into intraday effects on the
spread variance at market open and market close. One can expect that the
spread variance is high around those periods and lower during the middle of
198 RISK ARBITRAGE PAIRS
FIGURE 12.3 Kalman Smoothing with Confidence Bands (AZA-SEQU, lag 5).02040 60 80 100 120–3–2–101Log (Spread)