Speculating on a Tender Offer Using Options: The Case of Rjr Nabisco, Inc.

CASENET, SOUTH-WESTERN COLLEGE PUBLISHING

Posted: 11 Dec 1996

Date Written: Undated

Abstract

SUBJECT AREAS: Option strategies, risk arbitrage, tender offers.

CASE SETTING: 1989, options markets, takeover contest.

In 1989 Kohlberg, Kravis, and Roberts acquired RJR Nabisco in exchange for a combination of cash and securities. Over the weeks while RJR was a target, prior to the successful completion of the acquisition, option prices were apparently anomalous: American puts traded at a large premium relative to calls, with the premium increasing in the strike price. The case raises two questions for students to answer: 1) why did this option pricing "anomaly" occur, and 2) how could options have been used to speculate directly on the success of the takeover.

The answer to the first question turns out to be that the tender offer created a cash flow for RJR shareholders similar to a dividend. Understanding this point and deducing the pricing implications requires that students understand the mechanics of the tender offer (which is thoroughly detailed in the case), put-call parity, and the economics of a short sale. The second question permits students to play with a large variety of option strategies. The strategy suggested in the case is a box spread. The case solution shows that the cost of the box spread provides an estimate of the risk-neutral probability that the acquisition would be a success. This point can be illustrated for students simply by considering the values of the various options when the takeover succeeds and fails.

The case has been used successfully with both introductory and advanced option students. It can be taught at a variety of levels. Beginning students can tackle the question of why option prices violate parity, while more advanced students can delve into the box spread strategy. An Excel file containing daily stock and option price data for RJR is available.

JEL Classification: G34, L66

Suggested Citation

McDonald, Robert L., Speculating on a Tender Offer Using Options: The Case of Rjr Nabisco, Inc. (Undated). CASENET, SOUTH-WESTERN COLLEGE PUBLISHING, Available at SSRN: https://ssrn.com/abstract=9193

Robert L. McDonald (Contact Author)

Northwestern University - Kellogg School of Management ( email )

2001 Sheridan Road
Evanston, IL 60208
United States
847-491-8344 (Phone)
847-491-5719 (Fax)

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