Merger arbitrage: Arbitrage trading takes advantage of momentary differences in price quotes from various forex (foreign exchange market) brokers and exploits those differences to the trader’s advantage.
Essentially the trader relies on a particular currency being priced differently in two different places at the same time.
Trading arbitrage is not recommended as a sole trading strategy . It is also not advised for traders who have small equity accounts, because trading arbitrage requires a large amount of capital.
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Merger arbitrage
1. What is Merger Arbitrage
Public companies, unlike privately held companies, are listed on the financial markets of their respective nation, and often on more than one exchange. Organisations usually use the avenue of taking a company public in order to raise more capital in order to expand and grow the business or ensure that it stays afloat. Other benefits of taking a company public include being able to use stock prices as a barometer of the organisations performance as well as opening up more avenues for securing loans (aka more capital).
Read on: 8 Tips on How to do Flash Loan Arbitrage
However, taking a company public also exposes it to the vagaries of the financial markets and its regulators, in that the management will not be able to take actions in isolation and that the company will have to adhere to various policies set by the financial regulator. Further, and most importantly it also opens up the company to be taken over (i.e. purchased by another company). This can often be heart wrenching if the management and board consists of founder owners or people who have invested significant time into the company.
Merger arbitrage
The rationales to target and acquire or merge with another company are many. At a very basic level it could be divided into 1) Strategic Buyers 2) Financial Buyers 3) Raiders / Activists.
Usually, such corporate actions are usually preceded by announcements in the financial news. Under normal circumstances, the target company’s stock price rises (or falls) to the offer price set (usually part of the announcements). Thus, merger arbitrage is the quick purchase of the stock of a target company and selling the shares on increase of its price.
See also: How to trade forex in Nigeria
2. Essential Terminologies
Let’s start with looking at the basic terminologies which are used and which I shall also be using throughout the course of this article
- Arbitrage — The ability to earn or generate profits with zero or almost minimal risk.
- Buyer / Acquirer — The company which makes an offer to another company so that it can purchase it
- Target — The organization which is the target of the buyer’s purchase bid
- Merger — The situation where two companies merge together to form a single company.
- Acquisition — A process by which a business (company) purchases another company. The purchase may be settled by Cash, Shares, or Assets
- Friendly / Hostile Takeover — A situation where the target does not want to be acquired by the buyer company is a hostile takeover. A friendly
- Tender Offer — An occasion where the buyer makes an offer directly to the shareholders of the target company rather than the board & management in order to increase its shareholding. A self-tender offer would be an offer by a company to its own shareholders for repurchasing of its shares
- Cash Offer — An acquisition or merger where the buyer pays the target company with cash
- Shares Offer — Same as cash offer except that the target is offered a ratio of the buyer’s stock in exchange
- Short — To bet against a stock, or more simply betting that a stock’s price will reduce
3. Where to Begin — Process Overview
News Sources & Announcements
Assuming that we are individual investors who don’t have the luxury of following the markets 24×7 unlike the big boys and girls (read institutional investors) of finance, the first place to begin with will be looking out and staying up to date with financial news.
Thus, if one has a brokerage account which allows investing only in the USA, it would make more sense to look out for news which concern companies which are listed on either the NYSE or the NASDAQ as it will only be on these deals that we will be able to seek and act on an arbitrage opportunity. So as mentioned above, one could look at various news sources.
Read also: 18 Tips to Make a Successful Forex Trading Business
4. Verification and Analysis
Once the news has been identified the next step would be to verify the news with other news sources and websites. The news sources I mentioned above are highly trustworthy sites and are likely to be very accurate in their reporting.
After verification, you will undertake a quick analysis of the stock of the target company and calculate the potential returns which you could earn by acting on the arbitrage opportunity. In order to undertake the analysis, do look out for the terms of the deal in news announcements.
It is during this stage that you will decide upon a price at which you will look to sell the stock.
5. Understand the foreign exchange market.
The foreign exchange market, commonly referred to as forex, is an international exchange for the trading of currencies. It allows investors (from large banks to individuals and everyone in between) to trade one national currency for another. Each trade is both a purchase and a sale, as one currency is sold in order to buy another one. This duality means that each currency is priced only in relation to another currency. In other words, a U.S. dollar has a price only in terms of British pounds, Japanese yen, Mexican pesos, or some other national currency.
6. Learn about arbitrage.
Arbitrage is the practice of buying an asset in one market and immediately selling it at a slightly better price elsewhere. In theory, a given currency should carry the same price in different markets. However, market inefficiencies (often resulting from communication difficulties) may result in different prices emerging in different locations at the same time. Arbitrage takes advantage of these inefficiencies to the benefit of the trader.
- For example, if a trader recognizes that a currency can be bought for less in one market and sold for more in another, he could then make those trades and keep the difference between the purchase and the sale.
Read on: How to Start Forex Business
7. Know how to use arbitrage to make profitable trades.
Forex traders take advantage of minor price differences by buying currencies where they are less valuable and selling them where they are more valuable. This usually involves multiple trades of intermediate currencies in practice. Intermediate currencies are other currencies used to express the value of the currency you are trading. You wouldn’t just buy and sell U.S. dollars, for example. You might buy euros with your dollars and sell them for pounds, with which you could then buy dollars.
- For a more specific example, imagine that you could use 2 American dollars ($) to buy 1 British pound sterling (£), then use that pound to buy 1.50 euros (€), and then use the l.50 euros to buy $2.50. By trading this way you have gained $0.50, simply by exploiting price differences.
- In the real world, price differences would never be this extreme. In fact, they are usually fractions of a cent. Traders make money by trading in large volume. Volume trading allows traders to make enough profit to offset transaction fees.
- In addition, traders must overcome the fact that arbitrage opportunities may disappear only a few seconds after first appearing (as markets adjust to correct the difference in pricing). Institutional traders rely on computers and automated trading to buy and sell currencies quickly enough to stay ahead of the markets.
8. Know how to read currency prices.
Market prices are expressed in a very specific way. As mentioned, currencies are priced in relation to other currencies. The US dollar (USD) is often used as a base currency in determining values. For example, the value of the Japanese yen (JPY) will be expressed as a ratio of dollars to yen (USD/JPY).
- The relative values of currencies are generally expressed to four decimal places. For example, the euro-to-dollar rate might be expressed as 1.1156 EUR/USD. This means that at a given moment it would take 1.1156 US dollars to buy one euro.
9. Determine what currencies to use.
In order to have a triangular arbitrage, you must compare the exchange rate of three “currency pairs” that you can trade between. An example of this is the EUR/USD (euro/dollar), EUR/GBP, (euro/Great Britain pound) and GBP/USD (pound/dollar). As in any such triangular arrangement, there are three currencies involved, and each currency is paired separately with each of the other two.
Related: 11 Ways of Understanding Arbitrage and The Forex Market
10. Get the current exchange rate for each pair.
You can find the current exchange rate in your forex broker’s software (if you have a forex broker) or on websites that have the current exchange rates listed. For illustration, assume the following exchange rates for the euro (EUR/€), the British pound (GBP/£), and the U.S. dollar (USD/$).
- Exchange rate of EUR/USD is 1.2238, which means that you will have to spend about $1.22 to buy €1.
- Exchange rate for GBP/EUR is 1.1910, which means that you can buy £1 for about €1.19
- Exchange rate for GBP/USD is 1.4650, which means that for £1, you can buy about $1.47.
Merger arbitrage
11. Purchase & Selling the Shares
Post-analysis, it is prudent to purchase the stocks of the company / target in question. It is advisable to invest at least $1,000 or at the very minimum a sum of $500. A lower amount will eat away at your profits because of commission fees and taxes thereby reducing your net earnings.
Repeat!
As one gains experience with arbitrage, he/she can devise personal techniques to undertake analysis or strategies for exploiting the arbitrage opportunity.
Let us now walk through two simple examples of merger arbitrage. For the purpose of this article, let’s look at a factional all cash and an all share transaction, followed by a live case.
View also: : Today’s Forex Market News
12. Calculate the arbitrage:
The arbitrage is made by buying and selling the correlating currencies against each other. Currency is traded in what are called “lots.” Standard lots are blocks of 100,000 units of a currency, and mini-lots are blocks of 10,000 units.
- Imagine you have the ability to make a leveraged trade with $500,000. A leveraged trade is one made mostly with debt.
- Spend your $500,000 to buy euros. Because the USD is on the bottom of the exchange quote (EUR/USD), divide the $500,000 by the quoted amount. So $500,000/1.2238 would net you about €408,560.
- Sell the euros for British pounds. Because the euro is on the bottom of this exchange rate (GBP/EUR), we divide the number of euros by the exchange rate to get the number of pounds. So, dividing €408,560 by 1.1910, we get about £343,040.
- Sell the British pounds for U.S. dollars. Here, the GBP is on top of the quote (GBP/USD), so we multiply the number of pounds by the exchange rate to get the number of USD. So, £343,040 multiplied by 1.4650 yields roughly $502,550.
- Determine your profit. You started with $500,000, and you now have $502,550 after a few simple trades. Your profit is $502,550 – $500,000, or $2,550.
13. Get access to a forex trading platform and software.
Brokers and traders who trade arbitrage don’t calculate arbitrage manually. They use software programs that can identify opportunities in the market and calculate the arbitrage in seconds. The software can be set up to buy and sell at the precise moment that the opportunity arises. You can access similar platforms online and trade in the forex market. Search for “online forex trading” to see what types of software are currently available.
- Be aware that many of these platforms charge a trading fee. Such a fee will diminish (or even erase) your profit on each trade, particularly if you’re trading with limited capital.
Read on: 10 Ways to Improve Your Forex Trading Strategy
14. Example 1: All Cash Deal
News & Analysis
Consider two fictitious companies, Winston Railroad and Avenell Transport, whose stock tickers are WRR and AVT respectively. Assume that the shares of Avenell Transport are trading at a price of $24 on Day 0 (D+0) at 08.30 AM. At 09.45AM news filters through that WRR is looking to purchase AVT for $6.75B in an all cash deal. Let us also assume that you happen to have an intuition that the deal has a 70% possibility of being accepted and 30% probability of being rejected.
This means that WRR values the shares of AVT at $45 per share as compared to the current price of $24 per share. As soon as the announcement is made, the share prices are likely to start moving towards $45. Thus it is our intention to hold a position in AVT for as low a cost as possible. However, before we place orders we run a quick analysis of our potential returns to calculate our potential profits.
Here, we have assumed that we purchase the shares of AVT at $35 because of the time lost in our analysis .
Further, we adjust our net profit by multiplying the probabilities with the potential upside and downside (downside = purchase price — initial share price) which gives us a profit of $318 with an annual return of 22.2% assuming that you closed the trade after approximately 6 months and invested $3,000 in the trade. Feel free to play around with the values in my sheet to better understand the calculations. The cells which need your input are highlighted in gray.
Merger arbitrage
15. Example 2: Share Offer
Consider both WRR and AVT once again for the purpose of this transaction. Except in this case, WRR offers AVT 0.55 shares for every share of AVT (i.e. for every share you hold of AVT you will receive 0.55 shares of WRR). Assuming that on the day of the announcement WRRs price is $88, it implies that WRR values AVT at $48.40 (0.55 x $88). The key here is that the deal hinges on the price of WRR shares, which are liable to fluctuate every trading day.
Assuming you purchase AVT shares at $35 and the price of WRR shares on the deal day is lower than that on the day of announcement ( $75 vs $88), you will earn a net profit of $535.71. The warning WRR price will indicate at which price of WRR shares you will be in the red. In order to overcome / hedge yourself against this risk, one could short 47.14 shares of WRR and exchange and close them on the final day if not earlier. This trade earns a return of 39% annualized.
See also: How to Become Rich in Forex Trading Business(21 tips)
Merger arbitrage
16. Real World Example
It was reported by Bloomberg on October 08th at 07AM that AMD was in talks to purchase Xilinx for $35B in an all share deal. AMD would therefore offer 1.72 of its own shares per Xilinx share held, implying a per share equity valuation of $149.84 of XLNX. Had one acted quickly and invested $3,000 into XLNX shares at a price of $120, one could achieve a profit of 38% annualized on the deal ($0 commission costs).
It is also interesting to follow the chart of both the companies commencing from the date of the reporting of the potential deal between AMD and Xilinx on October 08th. It can be seen that XLNX stocks jump up to $120.94 within a day
As this is a share offer, as long as the price of AMD hovers nearabouts $80, it is safe to assume that the share price of XLNX is likely to reach the mid to late $140s. Running the numbers (see above image or spreadsheet) will allow to calculate the potential future payoff if one invests in the opportunity. Even today, if we go and buy XLNX for $129 and AMD hovers at $79, a 7% return is there for the taking. You can read more about the deal here.
17. Beware of faulty arbitrage programs.
There are forex arbitrage software programs for sale online. Before using these programs on a real account, try them on a demonstration account first. This will prevent the loss of money through the use of faulty software. Have an experienced arbitrageur recommend software and trading platforms.
Merger arbitrage
18. Look for arbitrage opportunities.
Some online forex trading platforms offer calculators or automated programs for finding arbitrage opportunities. Take advantage of this service if your trading platform offers it.
- You can also use an independent forex arbitrage calculator to determine if an arbitrage opportunity exists. These are available online, sometimes free and sometimes for a fee. Try searching for “arbitrage calculator” to find one.
Read on: Why you Should use Forex Algorithmic Trading Techniques
19. Don’t hesitate.
It doesn’t take long for markets to correct themselves when an arbitrage opportunity presents itself. You’ll have to act quickly to make a trade before the chance is lost. Once you see a price difference, grab it immediately.
- The reality is that with the current level of technology and ease of worldwide communication, forex arbitrage is typically profitable only for large financial institutions with lightning-fast trading systems. This is because arbitrage opportunities usually evaporate in a matter of seconds.
Merger arbitrage
Concluding Thoughts
I would like everyone to take note of the fact that there exist various risks undertaking such trades and that as an individual one is likely to be competing with institutional investors armed with thousand dollar terminals and news sources.
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Never trade on an online platform that is not properly certified. If you’re unsure, err on the side of caution and stay away.
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Assuming the software being used is working properly, forex arbitrage (whether in currency or in other assets) is commonly considered to be risk-free for the trader. Nonetheless, an investor is well advised to learn all he or she can about the process before committing money to it.
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If you are considering the use of leverage (debt) to make forex trades, this can potentially magnify your losses greatly. Be aware that you could lose a substantial amount of money this way if your trades go poorly. In other words, don’t leverage until you know exactly what you’re doing.
To conclude, I hope this simple primer on merger arbitrage has given you a peek and basic understanding of this practise and I hope this has piqued your interest to explore this further.