I asked this question from my students in the mid-term exam at MDI today.
Risk Arbitrage Template # 1: Base case of risk-free open offer
Company A’s stock price is quoting at Rs 35 per share. Suddenly, a competitor of Company A makes an offer to buy out all the outstanding shares of the company at Rs 100 per share. The stock promptly zooms up to Rs 80, at which price you can buy a large quantity, if you wish.
You and your friend have evaluated this risk arbitrage opportunity. Here are your findings:
- The last date for a competitive bid has gone by, so the probability of a higher bid is zero.
- The bidder cannot, of its own accord, withdraw the bid and has deposited all the money required to fund the offer in an escrow account under the control of a highly reputed bank. Moreover the investment banker who has made the public offer is highly trustworthy.
- The offer is likely to be completed within 90 days if it’s approved by the Competition Commission of India (CCI). The deal is subject to approval by the CCI because the bidder is a competitor of Company A.
- In your estimate, the probability that the deal will get approved by the CCI is 80%.
- In the event of the deal not being approved by the CCI, the offer will be withdrawn.
- If the offer is withdrawn, the stock price will plummet back to Rs 35 level, which was the price in the market before the bid was announced. However, in your estimate, if such an eventuality arises, you should be able to sell all your shares in the market at an average price of Rs 50.
Questions on Template # 1
- Assume that you are looking for opportunities which are uncorrelated to the market, why should you invest in this one? (10 marks)
- How would you act if CCI approval was not granted and you have bought the shares? How would you psychologically respond to that situation? (10 marks)
- If your friend refuses to make this bet because of the loss scenario, what bias is he suffering from? (10 marks)
- How would you help him over-come this bias? (10 marks)
The Purpose behind this “experiment”
This is an experiment in teaching and learning from each other. Let’s see how it goes. If it goes well, I will repeat this experiment by introducing newer problems.
This current problem is a hypothetical one but serves as a really good basic template for working on risk arbitrage. In my view, risk arbitrage is an excellent building block for learning value investing because it requires a mindset of an unbiased, unemotional, and rational decision maker. Moreover, it does not require making long-term predictions about businesses, managements, or the economy.
This is an invitation to you to answer the questions listed above. I will accumulate the submitted answers over the next three days i.e. until 23 October 5:30pm. I won’t approve answers until the deadline has passed.
Once the deadline has passed, I will approve all the answers posted. Then, if needed, I will add more, complex questions. The process of questioning and answering will follow a method used by Socrates and which is called “Socratic Questioning”
Socratic questioning is disciplined questioning that can be used to pursue thought in many directions and for many purposes, including: to explore complex ideas, to get to the truth of things, to open up issues and problems, to uncover assumptions, to analyze concepts, to distinguish what we know from what we don’t know, to follow out logical implications of thought, or to control the discussion. The key to distinguishing Socratic questioning from questioning per se is that Socratic questioning is systematic, disciplined, and deep, and usually focuses on fundamental concepts, principles, theories, issues, or problems.
Hopefully, the process of Socratic questioning will produce some really good insights.
The person who submits the best answer and subsequent insights will be awarded a copy of “Thinking, Fast and Slow” by Daniel Kahneman. Just a small incentive for achieving a higher end. 🙂
Model Answers Template # 1
Many of you have given excellent answers. I will keep the answer brief because I want to spend time on the concept and also on taking the topic to the next template.
You should invest in this opportunity if you are looking for good bets which are not correlated to the market provided that it’s a small bet and it offers returns which are superior to a bond investment. As Ankur Jain (my ex-student and colleague) points out, we need to know the prevailing interest rates. The prospect of earnings Rs 10 on an investment of Rs 80 over a period of 90 days which translates into a flat return of 12.5% and an annualised return of about 51% looks very good because in the back of our mind we know that prevailing interest rates are much lower. But if India was going through hyper inflation and nominal interest rates were higher than 51% p.a., this would be a bad trade.
If CCI rejects the acquisition proposal then the offer stands cancelled and reason for owning the stock no longer exists. This sale will result in a loss but that is part of the (probabilistic) game we are playing. It would be foolish to anchor to cost (anchoring bias) or find new reasons to own the stock (commitment bias).
The correct psychological response to the loss scenario is to swallow your pride and to take the loss by “thinking like a trader.” You can console yourself by thinking “you win some, you lose some.” In other words, focus on process not outcome. Good processes in the probabilistic world of Fermat and Pascal sometimes result in bad outcomes. By keeping the eye on the process and being unemotional is the right psychological response.
If your friend refuses to make this bet, he is suffering from loss aversion. This is a very common bias and was discussed beautifully by Daniel Kahneman in his book “Thinking, Fast and Slow.” See this link titled “Samuelson’s Problem.” Risk arb teaches how to get out of loss aversion extremely well. If you don’t take losses which are going the occasional but inevitable outcomes of even good investment process, you won’t last very long in this game. That’s one huge reason why I consider doing risk arb as a great building block for other forms of value investing.
Kahneman also provides an elegant solution to the problem. Carefully read “Samuelson’s Problem” to find it. Many of you have referred to this “death bed problem” by using terms like “broad framing” and “loss aversion” in your answers. Those of you who have done this are bang on target.
Socratic Solitaire with Risk Arbitrage Template # 1
I talked about the idea of socratic solitaire in an earlier blog post. I will use that idea again over here by asking some questions and answer them myself.
Question: Why a small bet? Why not bet the bank on such bets? After all they have large, positive expected payoffs!
Answer: Because there is a scenario where you may lose Rs 30 on a Rs 80 investment. That’s a loss of 37.5% of the capital invested in the operation. Moreover, the probability of this scenario is not tiny. It’s 20%. That’s why you will never make large bets in these situations? Look at this way: If you invest your entire bankroll on a series of such bets then a day will come when you will lose 37.5% of your capital. That would be bad financially. It will also be psychologically devastating. You don’t want those outcomes.
Question: Ok, then what about another bet, which has the same expected return but the loss scenario isn’t there at all?
Answer: In that case, you should willing to invest a higher amount than you would in the previous bet.
Question: What about fundamentals? Don’t I need to worry about that?
Answer: For the most part, no. In later templates, maybe but not in Template 1.Why? Because the offer is for all the shares, you are effectively buying, not the stock of Company A, but the bonds of offerer. Your analysis of this situation is the functional equivalent of doing credit risk analysis on the offerer. (This, by the way, is a very good example of a situation when a stock becomes a bond and where you should focus on underlying economic realities and not titles. As Shakespeare wrote: “What’s in a name? A rose by any other name will smell just as sweet.”)
If CCI declines to approve the deal, the offer will fail. When that happens, the instrument will cease to be an effective bond of the offerer and will start trading like a stock — like it did before the offer was made. In other words, it will crash. But since you’ve already decided to get out if that happens, fundamentals won’t matter much won’t they?
But, what if the stock keeps on tanking limit down every day and you can’t get out? This can happen because there are other arbitrageurs like you who are rushing for the exits. To all of you fundamentals don’t really matter here.
However, if the stock keeps on falling, a time may come when you will have to start thinking about fundamentals. 🙂 Tough luck! Just think about this for a moment. You bought a stock at 80 to make Rs 20 on it. Your return is CAPPED. Now the deal has collapsed because the CCI said no. The stock is selling at limit down every day and you can’t get out. It’s now at 20. What will you do? No matter how unemotional you are being asked to think about the situation, you will have the temptation to dig out that annual report, calculate the book value, economic earnings etc and consider holding on to this stock.
The idea of capped small absolute returns combines with the possibility of large losses can be remembered with the help of a powerful metaphor of “picking up pennies in front of a steamroller.” The money you make if things go right is small, and the money you lose if they go wrong is large. Keep that in mind when you plunge into risk arbitrage.
Btw, metaphors are very powerful way of thinking about the world around you and just like multiple mental models, you need a multiple metaphor framework.
Question: Ok, now I am really scared. Why do risk arb at all?
Answer: Two big reasons. One, it has a role in portfolio management. Recall low or no correlation to markets. That’s very attractive. When there’s a bull market on and you can’t find good stocks to buy, risk arb comes handy. It’s like a high interest lending operation. Money goes out for a short while, earns a good return (averaged out, if you do it right) and then it comes back, by which time stock markets may be lower and you may find a longer-term home for your money. So, one may think of money invested in risk arb as a cash equivalent but there are exceptions to this rule, as we will discover in a later template.
Two, you may want to do only risk arb and nothing else. Some people do that. It’s a lot of fun, and open offers are just one type of a risk arb operation. There are several more. Graham used to call them “special situations.” You can read up about a few I have done long time ago from here and the original “special situations” article by Ben Graham from here.
Question: Ok, I am back in the game! But tell me what can go wrong.
Answer: Like I said, you are effectively picking up pennies in front of a steamroller. Remember this: most surprises in risk arb are bad ones (asymmetric payoffs). There may be good surprises (we will discover them in future templates), but bad ones outnumber good ones. So, you have to keep on worrying about what can go wrong, where is the risk etc. While doing so, it’s a good idea to keep Robert Rubin’s observation about risk in mind: Condoms aren’t completely safe. My friend was wearing one and he got hit by a bus. 🙂
That Rubin quote is very powerful advice on risk for risk arbs. Rubin, by the way, spent a good part of his earlier years in risk arb.
Question: Very funny! When should I sell out of this situation?
Answer: When you’re wrong, when something better comes along and you don’t have spare cash, or when you’ve made most of the money that you wre going to make in this trade. Here I have a rule of thumb. You bought it at 80. The max you can make is 100 so that’s 20 points. Now, let’s say 80% of those points are already in the bag. That is the stock price has risen to 96. From here onwards, out of a total 20 points, only 4 remain. For me, it’s a good idea to let someone else take the risk on those points. Keep Rubin’s advice in mind. If you hold on at 96 and some shit happens then you will lose the return and you may also lose your shirt. Why take the chance?
Question: Ok, makes sense. But who will buy from me?
Answer: Traders who want to buy today and tender in just a few days. Obviously if the stock has risen to Rs 96, this means that the offer is just about to close. The fellow who buys at 96 from you and sells it at 100 to the offerer makes 4 bucks on 96. That’s a 4.2% return. If he is going to make that return, say, in a week, then his annualised return comes to 217%. And you made a lower IRR in percentage terms, but look at it this way: who got most of the juice out of the trade? You! You let him have the rest of it because you figured that the remaining part of the return is just not worth the additional risk. There are two very important lessons here. One, don’t be fooled by a percentage.
And two, in risk arb there is no hold period. Either you are a buyer, or a seller. If the price has risen to 96 and you are not a buyer at this price, you should sell. That logic does not apply in buying long term equities where there is a price range for buying, holding, and selling. Now, I know many smart people who argue against this but that’s the way i feel about it. People who argue against this view are thinking like traders even for long term opportunities… But I diverge, so let’s get back to the topic.
Question: Ok, I understand that it’s rational to accept these types of bets because they are favourable bets, and they are small wagers so even if the loss scenario arises out of bad luck it won’t kill you. Why would someone reject such a bet then and still be rational?
Answer: Good question. The answer depends on how we define rationality. If we look purely at the investment merits, everyone who is looking for uncorrelated special situations should make this bet. But we have to think about incentives and perverse incentives. What if you are managing a fund in which if you get a bad outcome, it will look bad on you. Under such circumstances, in the interest of self-preservation, would it not be rational for the fund manager to reject such bets because they carry a not-insnificant loss scenario? So, on top of expected value framework, there is a “regret analysis” framework. Buffett ignores the “regret analysis” framework because over decades he has positioned himself in a manner which allows him this privilege. He does not care about short term performance, lumpy results. In his words, “we are willing to look foolish, so long as we are sure we have not acted foolishly.” Not many people have that privilege.
Risk Arbitrage Template # 2: Partial Offer
Ok, now we move to the next template where we increase the complexity a bit.
Company A’s stock price is quoting at Rs 35 per share. The promoters of the company, who hold 51% of the company’s shares sell out to a MNC at Rs 100 per share. The MNC makes a tender offer for an additional 26% at Rs 100. There is no regulatory risk like the CCI risk in template 1.
The stock has risen to Rs 60 per share. After the offer is over, you expect the stock price to fall back to the pre-offer level of Rs 35 which is also the price at which you will be able to liquidate your remaining shares. The offer will take 90 days to complete.
- What’s the expected return of this operation?
- Should you look at fundamentals of the target company? Why or why not?
- What is the likely acceptance ratio i.e. how many of your shares are likely to get accepted under the offer (theoretical vs. practical) and what key factors will govern that ratio?
- How can you use the “inversion” (invert, always invert) trick to estimate market’s assessment of the acceptance ratio?
- Should you borrow money to do this operation? Should you have done it in Template 1? Why or why not?
Try to answer these questions. This time, I will approve responses as they come in and give my own views in a while.
Then, we will go to the next template.
Model Answers Template # 2
Again, we have excellent answers in comments. Without being too repetitive, here are my thoughts.
If everyone who is eligible to tender, tenders, then the operation involves:
Buying 100 shares @ Rs 60 resulting in cash outflow of Rs 6,000
Tendering all shares, getting 53 (=(26/49)*100) accepted at Rs 100. Cash inflow Rs 5,300
Selling the remaining 47 shares @ 35, resulting in a cash inflow of Rs 1,645
Ignoring time value of money and taxes (you can easily factor the former by using XIRR function in Excel), we find that for laying out Rs 6,000 we get back Rs 6,945. Accounting pre-tax profit of Rs 945 translates into a return of 15.75% over 90 days which annualises to 64% p.a. Not bad at all.
The actual return will be higher because not every one who is eligible to tender will tender. That’s discussed below in Answer 3.
Since you’re going to end up with some shares, you have to think about fundamentals. What if underlying value is far below Rs 35 — the level at which the stock was selling before the offer. What’s the sanctity of this Rs 35 number? It’s just a number — an anchor. We need anchors but not the wrong ones. The right anchor here is the underlying value and not the price at which the stock was selling before the offer.
Another danger here is to think along these lines: Well the acquirer who is buying is not a fool and if it’s paying Rs 100, then I can assume the stock won’t fall below Rs 35. This maybe true and maybe not. So, don’t fall for the bias from over-influence of authority, unless you have very good prior evidence to support the belief that the acquirer is not a fool. For example, Ravi Purohit has cited examples of two acquisitions done by a group, which has a solid track record in M&A.
People have generally stated correctly that the actual acceptance ratio will be higher because not everyone will tender. Here it’s important to think in terms of base rates. There is plenty of statistical evidence on tender offers from where these base rates can be calculated. While studying any given offer, it makes sense to first start from base rate and only then adjust that base rate probability by taking into account the peculiarities of the situation you’re evaluating.
Many people discard the base rate and start modelling their excel sheets by assuming a much higher proportion of non-tenderers (called “brain dead” investors in Risk arb parlance because these people won’t tender at 100 but will sell in the after-market at 35). Excel is a dangerous tool. It allows you to insert what you want to believe, as if it’s a fact. So, if you want to believe that a particular institutional investor who holds 10% stake, will never tender because he bought it at a higher price than the offer price of Rs 100 (loss aversion), then your model will project a higher acceptance ratio than would be the case if you had assumed that he would tender. And that would make the trade look profitable at a higher price and you’ll go and buy and later find that he tendered and acceptance ratio was not as good as you had projected and you ended up with either much less profit or even a loss.
So you have to exercise caution when making predictions about acceptance ratios. The outcome of the trade is likely to be highly sensitive to your predictions of acceptance ratios. It makes sense to do a scenario analysis and the trade may become uninteresting in the pessimistic scenario. Now that won’t happen in our example above because even if everyone tenders, the trade still makes sense, but it will happen in other situations.
One thing I have learnt here is that it’s just stupid to assume that a fellow won’t tender because “its rational to not tender.” Think about this for a moment. As value investors, we make a living by trading against irrational people. We think the world consists of a large number of irrational people and institutions. And yet, when it comes to risk arb, we tend to fool ourselves into believing that people will be rational when it comes to tendering shares. They wont always be. So, don’t implicitly apply the human rationality assumption.
The inversion trick is a very powerful idea because it de-biases us. We want to believe that LIC won’t tender or HDFC won’t tender and that will make the acceptance ratio so much better so we want to buy. Why not invert and figure out what the market price is telling us about the likely acceptance ratio, and then see if we agree or disagree with the market? Without going into the details, here’s the procedure.
We already know the offer price (Rs 100) and the current stock price (Rs 60). We know the time to closure (90 days). We have estimated the likely exit price for remaining shares (Rs 35). We also know that risk arbs will do a trade by insisting upon a return which is higher than the risk free return. So, let’s say the risk-free return is 10% p.a. and risk arbs required return is 14% p.a. We can plug in the 14% p.a. return to figure out the acceptance ratio which will deliver that return. Once we have that ratio, we can then approach the problem more objectively. Inversion, or backward thinking accomplishes just that: it makes us more objective. By thinking forward (i.e by estimating acceptance ratios by studying shareholding patterns, and base rates), we are prone to making mistakes. By thinking backward, we create a sanity check on thinking forward. So, we must use both types of thinking — forward and backward.
What should you do if the “implied acceptance ratio” by reverse engineering it from the data we have turns out to be way more than what you estimated by thinking forwards (using base rates, and then adjusting for them with the peculiarities of the situation being examined)? You should walk away from the trade. You have arrived at a conclusion that people who are setting the price in the market are over-optimistic.
Could there be alternate explanations? Yes! You may be competing with people who don’t have to pay taxes and/or have much lower transaction costs than yours or have access to low cost borrowed funds. For such arbs, certain trades will make sense while they won’t make sense for you.
Regardless of explanation (overoptimism or low cost advantage), your conclusion will be the same: Walk away.
I agree with the conclusions given by most of the commentators. Borrowing in Template # 1 does not make sense because of a loss scenario. Borrowing in Template # 2, MAY make sense. I liked L.J’s comment that “We must also keep in mind the temperament of the investor. If borrowing money makes you uncomfortable and you have trouble sleeping at night, it might be better to avoid it.”
Socratic Solitaire withe Template # 2
Question: You have no clue whether an institutional investor will tender or not. How will you deal with that in your model?
Answer: I will toss a coin. In other words when I don’t know, I will simply be agnostic and assume a 50% chance of tender and in my model.
Question: How will you turn English words like “highly probable” “almost certain” “likely” “unlikely” etc into probability percentages?
Answer: I will use Sherman Kent’s framework and will do it routinely as a practise in applying Fermat/Pascal way of thinking to virtually everything in life.
Question: Should you use Template # 2, to create cheap shares in a stock you want to own?
Answer: Yes! L.J has mentioned this important point in his comment. So has Ashim. The idea is very simple. You love a stock at a price. There is an offer outstanding at a higher price. You can buy more shares, tender them in the offer and lock in a gain on shares accepted. The profit on shares accepted should be thought of as a reduction in the cost of the shares that are returned. Sometimes, this can result in a fantastic opportunities. This happened in the case of Eicher Motors a few years ago.
So, even if you are not a risk arb, but are a long-term investor, it makes sense to temporarily wear the hat of an arb…
Question: But my accounting cost won’t change, will it? If I buy 100 shares at 60 and tender them all in the offer at Rs 100 and 45 of them are accepted, then my accountant will record a gain of Rs 40 per share on 45 shares, and leave the cost of remaining shares unchanged. But if I think in terms of cash flow, then there is an initial cash outflow of Rs 6,000, then a cash inflow of Rs 4,500, then, ignoring taxes, I have a net cash outflow of Rs 1,500 and I am left with 55 shares, so my effective cost of creating those 55 shares is Rs 27. So, who is right — the accountant or the cash flow investor?
Answer: The cash flow investor. You should ignore accounting consequences, and compare effective cash cost of creating new shares (after considering taxes which for simplicity’s sake, I have ignored), with fundamental information like earnings and asset values. The prospect of creating the shares of a high quality company at a very low P/E or P/B is very attractive.
Risk Arbitrage Template # 3: Stock Trades in F&O Segment
Ok, let’s add some complexity.
Company A’s stock price is quoting at Rs 35 per share. The promoters of the company, who hold 51% of the company’s shares sell out to a competitor at Rs 100 per share. The acquirer makes a tender offer for an additional 26% at Rs 100. It’s offer is subject to approval by CCI. In your estimate, the probability that the deal will get approved by the CCI is 80%. In the event of the deal not being approved by the CCI, the offer will be withdrawn. If the offer is withdrawn, the stock price will plummet to Rs 30 but the average price at which you should be able to sell all your shares will be Rs 35.
CCI will take 6 months to approve or reject the deal and then the deal will go back to SEBI for approval. Since the acquirer is involved in some litigation with SEBI on an unrelated matter, you think the offer could take a long time to be approved by SEBI, but you are confident it won’t take longer than 90 days after CCI decision. Thereafter another 30 days will be needed to complete the offer.
The bidder cannot, of its own accord, withdraw the bid and has deposited all the money required to fund the offer in an escrow account under the control of a highly reputed bank. Moreover the investment banker who has made the public offer is highly trustworthy.
Immediately after the announcement, the stock of Company A rises to Rs 65 per share. This stock also trades in the F&O segment of NSE and while options are quite illiquid, the futures contracts for each of the next three months trade at a premium to spot, reflecting cost of carry of about 12% p.a.
There is another potential bidder who has been giving media interviews about a counter offer. However, it has not come forward with a formal offer yet, and the last date by which it can do so will be 25 days from now.
In your judgment, in the absence of a competitive bid, the acceptance ratio is likely to be 67% of all tendered shares based on shareholding pattern as of now, before the offer, but since arbs are moving in, and there is a possibility of a competitive bid, things may change…
After the offer is over, you expect the stock price to plummet to Rs 35 — the price at which you will be able to liquidate your remaining shares.
- Will you buy now and hedge your net long exposure using futures? Why or why not?
- How will your estimate of acceptance ratio change over time?
- What’s the worst case scenario, if you buy now and also hedge using futures?
- How will you deal with the possibility of a competitive bid?
- How will you deal with the CCI risk and the SEBI risk in terms of a probability chain? (Hint: How many things have to go right for you to make money?)
- What kind of deal-related (not market related) volatility can you expect in this transaction? How will you deal with that volatility?
Model Answers Template # 3
In Template # 3, we experienced complexity like in messy real life. In such situations, different people, acting rationally, can come up with slightly different conclusions. Keep this in mind while you read my model answers to template # 3. Also focus more on the underlying principles on which I will rely rather than on the actual answers.
Let’s look at the base case of expectation of no competitive bid, no hedging, and transaction completing in 10 months (6 months for CCI + 3 months for SEBI + 1 month for offer formalities).
Let’s first figure out the acceptance ratio. The offer is for 26% our of a total of 49%, so the absolute minimum acceptance ratio is 53% (26/49). In the problem I have stated two things: (1) if there is no competitive bid, and no change in shareholding pattern, the acceptance ratio should be 67%; (2) since arbs are buying shares the acceptance ratio will change.
So the first major lesson here is to not estimate acceptance ratios based on old shareholding patterns. That’s because when arbs buy, they buy either to tender or to sell to other arbs, who will tender. So the shareholding pattern starts changing immediately after the offer is announced and the stock effectively starts moving from investors to arbs. This means that the actual acceptance ratio should be lower than 67%? So we need to model a lower acceptance ratio. A 67% acceptance ratio implied 39% of shares being tendered (26/39=.67) which means brain dead investors of 10% (49%-39%). Let’s model 6% brain dead investors instead of 10% because of arbs moving in. If we do that, then number of shares tendered will be 49%-6%=43% and acceptance ratio will become 60% (26%/43%).
So the first thing I have done is to recognise the unfavourable change in ownership structure in my model.
Now, let’s look at the base case.
Trade Today: Buy 100 shares for Rs 65. Cost: Rs 6,500
Sell in 10 months in offer: 60 shares at Rs 100. Total receipt: Rs 6,000
Sell in 10 month returned shares in market. 40 shares sold for Rs 35. Money received: Rs 1,400.
Total money received: Rs 7,400. Total money invested: Rs 6,000. Total return: Rs 900. Flat return in 10 months: 13.85%. Annualised return: 16.62%
Not bad, but not terribly exciting either. I can’t spike this return by borrowing because of a loss scenario (If deal falls all shares will have to be liquidated at 35).
Now, with this base case in mind, let me address the question with the observations that I very largely agree with Ravi Purohit’s replies. So let me just my perspective to his replies.
Identifying a deal and deciding the time to enter is are two different things. They need not co-incide. The key question to ask when you identify a deal is not should I buy but rather how can I make money in this deal?
It may make sense to buy the long position now but it does not make sense to short now. Why? To answer that consider what all can go wrong if you short a stock for hedging purposes. One, there are 10 months and you don’t have a futures contract for a 10 month duration, so you have to use shorter period contracts all roll them over. This exposes you to asset liability mismatch. In this particular case, if the arb interest is very high then the presence of shorts may make rolling over quite expensive.
Second, there is a possibility of a competitive bid. That possibility will become reality or disappear in 25 days. If you short now, you can get screwed if a large competitive bid happens. Why? That’s because the stock will shoot up and your short position will lose money. Moreover, you will find that you have over-hedged your position because with two offers on the table, the need to be short won’t be there. Two offers of 26% – one at 100 and one above 100 and total shares with public being only 49% makes shorting now a bad idea.
The general idea I want to invoke here is the idea of “preserving optionality” I wrote about this long ago, here and here. There is no point burning your bridges when the situation is volatile and dynamic such as in risk arb. The twists and turns in any risk arb is just another manifestation of the idea of volatility in option valuation. And options are worth more if volatility is high than when it’s not. So, keeping your options open till the last moment makes sense in risk arb. In the current situation, this means that considering shorting before the 25 day time limit for a competitive bid is over is a bad idea. And as Ravi has pointed out, the risk of deal failure due to CCI rejection won’t be known for 6 months so what’s the point of hedging now?
Why not break the trade into long buy at one time and short expected returned shares at a different time?
I have already address this above.
The worst case scenario is this: You buy now and you short now. Then there is a competitive bid and stock soars and you have loss on short position but which is offset by profit on long position. But since need to hedge has gone away because of two offers (so you think), you square up the futures at a loss but keep the long position intact. Then CCI rejects the deal and the stock collapses to 35.
As Ashim has mentioned, you have think in terms of decision trees and scenario analysis and expected value under various scenarios. As time moves forward some branches of your decision tree will disappear and new ones will appear. It’s a dynamic process — the very reason I like risk arb as a stepping stone for learning value investing generally.
You may decide to do nothing right now and wait for 25 days and then once the uncertainty about the competitive bid is over, work out the expected value at that time and then decide whether or not you want to take a position.
Alternatively, you may decide to take small long position now and then hope for competitive bid to materialise and then react to a bid materialising or not after 25 days. If it does materialise you may buy more shares, at a higher price and even if those news shares will cost you more and the return you will make on them will be lower than the return you make on the original quantity you bought, those lower returns will also come with lower risk of loss. So, you have to think of risk arb not in terms of just buy or not buy now but also in terms how much to buy and when always keeping in mind the dynamics of the situation. The same logic applies around the date of CCI approval. If the approval comes, the stock should move up. At that time you have evaluate if it makes sense to buy more or to liquidate the position. When you make that decision you will base it on your estimate of expected return as per information available at that time.
I have partially addressed this in the above paragraph. You have to think in terms of a probability chain. How many things have to go right for you to make money in this deal? The deal has to be approved by CCI, then by SEBI. If CCI approval probability is 80% and thereafter SEBI approval probability is 90% (you never know so you should not model certainty of approval), then the probability of both approvals coming through is 72%. And by the way these numbers are not static. They change. And you will know they are changing if you sit though the proceedings of CCI or reviewed SEBI approval process. So you have to change these probabilities based on new information and that could make the trade not worth doing or worth doing even more. What’s important here is to remember that its a very dynamic process and you have to keep on adjusting your estimate of returns based on events as they unfold. And while you do that keep in mind that decision trees expand by creation of new branches and also contract because of collapse of a few branches.
As mentioned by others, deal related volatility will revolve around: (1) competitive bid; (2) CCI approval; and (3) SEBI approval.
The award for the answers I liked the best goes to Ravi Purohit. Congratulations Ravi! And thanks a lot to the others for participating in this experiment.
Two Few Additional questions on Risk Arb
You have a number of risk arb opportunities and they offer different expected returns. Some expected returns are below AAA bond yields. Others are well above.
- How will you determine which ones to choose to invest in?
- How would you think about position size?