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Merger arbitrage or Risk arbitrage is a trading strategy often associated with hedge funds. Two principal types of merger are possible: a cash merger, and a stock merger.
In a cash merger, an acquirer proposes to purchase the shares of the target for a certain price in cash. An arbitrageur buys the stock of the target and makes a gain if the acquirer ultimately buys the stock at a higher price than his purchase price.
In a stock for stock merger, the acquirer proposes to buy the target by exchanging its own stock for the stock of the target. An arbitrageur may then short sell the acquirer’s stock and buy the stock of the target. After the merger is completed, the target's stock will be converted into stock of the acquirer based on the exchange ratio determined by the merger agreement. The arbitrageur delivers the converted stock into his short position to complete the arbitrage.