The Profitability of Risk Arbitrage in Mergers and Acquisitions

Abstract

If and why M&A arbitrageurs earn risk adjusted excess returns is a big unanswered question in the M&A literature. The goal of this study is to examine the risk and return relation of M&A arbitrageurs in different idiosyncratic and systematic environments. On one hand, deal characteristics create idiosyncratic risk for arbitrageurs by affecting the ex-ante probability of deal success. On the other hand, market liquidity conditions affect speculative spreads, which is the source of these arbitrageurs' profit. For example, when the market experienced the credit crunch in mid 2007, speculative spreads widened up dramatically. But both of these risks have not been taken into account in previous literature when examining M&A arbitrageurs` return. In this article, we empirically examine this risk and return relationship by considering both idiosyncratic and systematic risk including market liquidity risk. Our empirical study shows that deal characteristics, for example, the medium of payment, affects risk characteristics of these arbitrageurs' portfolios. Also, both idiosyncratic risk captured by the probability of deal success and market liquidity proxy by VIX affects M&A arbs' return. More importantly, after considering the liquidity risk they are bearing, M&A arbs are not making excess return.

This article contributes to the existing research on M&A arbitrage in two aspects. First, we provide evidence that M&A arbitrageurs bear both idiosyncratic risk and systematic liquidity risk. Second, we examine how excess return (à3B1) is related to different idiosyncratic and systematic market environments and shows that M&A arbs are not earning excess return.

Keywords: Risk Arbitrage, Mergers and Acquisitions, Idiosyncratic Risk, VIX

JEL Classification: G34, G39