'Risk Arbitrage' is explained in detail and with examples in the Investments edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.
Risk arbitrage is also known as statistical arbitrage. It is different from pure arbitrage as it involves risk or speculation. It is also far more accessible to retail traders than real arbitrage. Because of the reasonably high probability that risk arbitrage offers traders, experts generally consider it to be playing the odds. Despite the risk involved, this form of arbitrage has grown to be among the most practiced type by retail traders. Three main types of this arbitrage exist, liquidation, merger and acquisition, and pairs trading arbitrage.
Liquidation arbitrage is a kind that involves determining the liquidation value of a business’ assets. If a company possesses a book value of $100 per share and trades at $70 per share, it falls under this type. If the company determines it will liquidate, there would be an opportunity to make $30 per share on the dissolution of the company. When bigger companies practice this they buy companies whose parts are worth more than the whole of the company. They then sell off the various parts or assets to make money.
Merger and acquisition arbitrage remain the most practiced form of the strategy. The goal is to find a company that is undervalued at its current share price. If it is selected by another company as a takeover target, then it presents opportunity. The offer for this target will raise the company share price to near this level. The earlier investors get in on such a prospect, the more they are likely to profit from it.
If the merger does not go on as planned, the share prices will probably drop. Speed is the necessary factor to make this type of arbitrage work. Traders who practice this type usually receive streaming market news and trade on Level II trading. When a merger deal is announced, these traders attempt to buy in before everyone else does.
An example of this type of a deal would be a company trading at $40 which received a takeover bid for $50. The share price will rapidly rise towards $50 but not reach it until the merger actually closes. It might move to $48 per share. Those who get in on it immediately have a chance to make as much as $10 per share, or a 25% return. Others who buy in at $48 only have a $2 per share arbitrage opportunity for 4%. So long as the takeover happens as planned, both parties will make their returns. If it fails in the end for some reason, they will both likely take losses. The amount they lose depends on the price they paid and how far the stock falls back down on the failed acquisition.
Pairs trading arbitrage may be less common than the other two but it is especially useful in sideways trading markets. The idea is that investors find stock pairs which trade at a high correlation. They could be unrelated or related so long as their historical trading chart demonstrates that they trade in near tandem. Usually pairs with the greatest likelihood of success turn out to be larger stocks competing in the same industry.
The goal is to wait until one of these pairs has a price divergence in the 5% to 7% range. The variance also needs to last for some significant amount of time like two or three trading days. Investors then buy the cheaper stock long and sell the more expensive one short.
The last step is to wait for the prices to approach each other again. Once the prices are back in line, this type of arbitrage closes the trade and pockets the percentages they were apart initially. If the investor both bought the one long and sold the other short, then the gains can be twice the percentage the pair was apart.
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