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Abbot - Alza Case - Term Papers - Baskakov

13/2/21 上午12:38

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Abbot - Alza Case
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By baskakov, Jun 2012 | 4 Pages (860 Words) | 63 Views|

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Risk arbitrage (or merge arbitrage) is a trading strategy related to M&A transactions. For example, if an M&A transaction is carried out by means of share exchange between the buzzer and the target, then an arbitrageur may short sell buyer’s stocks and purchase stocks of the target. Until the acquisition is completed, the stock of the target typically trades below the purchase price. After the merger is completed, the target's stock will be converted into stock of the acquirer based on the exchange ratio predetermined in the merger agreement. The arbitrageur delivers the converted stock into his short position to complete the arbitrage. In an efficient capital market, the price of the target and acquirer will fully and immediately reflect the terms of the merger. However, risk arises from the possibility of deals failing to go through. Such possibility put the risk in the term “risk arbitrage”. Green circle had USD 500 million in AUM with 5% upper bound of position in a distinct investment (or 25 million). Smith arbitrage position was within the bounds or 13.5 million in short Abbot and 12.5 million in long position for Alza stocks. The proportion between Abbot and Alza shares was determined by the appropriate market prices of Abbot and Alza shares and announced exchange ratio of 1.2 Abbot sahres per 1 Alza share under the merger deal agreement. The potential return on investment could be up to 10% (or 19% annualized). Such high potential return on the investment is balance by the risk of deal break. For calculations please refer to Excel file sheet Q2. At the same time the expected return is a probability-weighted potential returns for different scenarios, e.g. either merge will be processed or not. Also it should be noted that expected return may change in time, i.e. probability of merge was high in June 1999, but this probability approached almost zero in October-November 1999. First excess return it’s return above the treasury security. In this case this deals has a lot of risk and possibility that deal will not be completed. So we should have positive excess return for risk that we take. We should keep in mind that we can remain without deals and try to 頁面 1∕3

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Abbot - Alza Case - Term Papers - Baskakov

13/2/21 上午12:38

should keep in mind that we can remain without deals and try to evaluate deals (short and long) separately with risk for each stock, volatility of it and other market parameters. Also we should evaluate probability of cancelation the deals after that we try to Market should prevent this profit as it contains risk. This profit isn’t risk adjusted we always have risk that deals will not be completed after calculating risk connected to deal we should find new price corrected by risks. Option strategy is a hedge for uncovered long position in stocks. If deal will be canceled Smith receive two positions: short in Abbot and long in Alza. For complete hedge he needs two option call in Abbot and put in Alza. If he buys put option for Alza he will hedge from price drop in Alza shares. But he still has risk in from rising Abbot shares. So he decreases risk of the positions. At the first glance it seems that expected return should be decrease as we decrease risk from strategy and pay money for this insurance (risk premium for option). If deal is canceled we will lose less money than without put option. There is a possibility than all market goes down before the deal and so we can additional return from exercise put option and also keep return from deal. To say exactly how will be change expected we should calculate probabilities of all possible situation, but based on risk arbitrage strategy we shouldn’t receive additional receive as it will be in moment executed by all market. If we were in Smith’s shoe we would keep the position but cover both sides with put option for Alza and call option for Abbot. With an open position as it is on Oct. 23, 1999 we would hedge long position in Alza with put maturing on Dec 31, 1999. And simultaneously cover short position in Abbot with call option. That would eliminate the risk of price volatility both for Abbot and Alza and minimize potential losses from the strategy. Doing that we save our possibility to make profit in case merge happen and fix potential downside at acceptable level. We did calculations for 2 case one case when deal will be completed (In this case our assumption then ABT price will be 1.2 times cheaper than AZA when option will be matured) we build scenarios for all possibilities price and evaluate options by B-S models and get result min: -$943k and average $3,7m cash we receive at the deal date. The second scenarios was that price of ABT and AZA is independent and normally distributed we calculated options prices and did 1000 simulations and get result min: -$2.4k and average -$0,5m. In these cases we have good hedge in bad situation when deal is break and loose not so much money in good case. But we loose 100% gain when deal is completed.

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Abbot - Alza Case - Term Papers - Baskakov

13/2/21 上午12:38

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