Risk arbitrage, or merger arbitrage, is an investment or 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. Until the acquisition is completed, the stock of the target typically trades below the purchase price. An arbitrageur buys the stock of the target and makes a gain if the acquirer ultimately buys the stock.
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 and buy the stock of the target. This process is called "setting a spread." 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.
1) Merger and Acquisition Arbitrage
The simultaneous purchase of stock in a company being acquired and the sale (or short sale) of stock in the acquiring company.
2) Liquidation Arbitrage
The exploitation of a difference between a company's current value and its estimated liquidation value.
3) Pairs Trading
The exploitation of a difference between two very similar companies in the same industry that have historically been highly correlated. When the two company's values diverge to a historically high level you can take an offsetting position in each (e.g. go long in one and short the other) because, as history has shown, they will inevitably come to be similarly valued. In theory true arbitrage is riskless, however, the world in which we operate offers very few of these opportunities. Despite these forms of arbitrage being somewhat risky, they are still relatively low risk trading strategies which money managers (mainly hedge fund managers) and retail investors alike can employ.