If you've been investing for some time, odds are that you've heard about arbitrage. Often, arbitrage comes up in the context of large financial institutions using it to make easy money at the expense of less sophisticated investors. The implication is that small investors can't hope to make money through arbitrage-based strategies.
However, while it's true that some arbitrage-based strategies require a significant amount of capital, there are other ways to use arbitrage even if your available capital limits you to making relatively small transactions.
A simple explanation of arbitrage
In general, arbitrage opportunities can exist whenever there are at least two different markets in which a particular good is offered for trade. Unless the prices in each market remain exactly the same at all times, any discrepancy in price can be exploited by alert investors. For example, shares of Royal Dutch Shell (NYSE: RDS-B ) are traded on the London Stock Exchange, as well as on the New York Stock Exchange through the use of American depository receipts. Theoretically, the prices of ADRs trading on the NYSE and Shell shares trading on the LSE should be identical -- at least during the hours each day during which both markets are open for trade.
Historically, the lack of instant communication and reliable shipping made arbitrage opportunities common. In modern times, advances in communication and shipping have reduced the number of pure arbitrage opportunities, which involve little or no risk. These days, index arbitrage opportunities on stock exchanges may involve microscopic differences in price that last a matter of seconds. Futures markets in different areas of the world may have slight disparities in the prices of certain goods, but as long as the disparities are small enough that the transaction costs of taking advantage of them would wipe out any potential profit, then there's no point in attempting an arbitrage strategy.
However, for those investors willing to assume a higher amount of risk, certain arbitrage opportunities that arise from proposed mergers between companies that are publicly traded are frequently available for any investors who want to use them.
Arbitrage opportunities in the context of corporate mergers can be divided into two basic categories: cash buyouts and stock buyouts. In cash buyouts, an acquirer offers to pay a certain amount of money to shareholders of the proposed target company in exchange for their shares. In stock buyouts, the acquiring company offers to trade shares of its stock to the target company's shareholders in exchange for the shares of the target company's stock.
With cash buyouts, the arbitrage strategy is extremely simple. Usually, after a company makes a cash offer to buy the stock of another company, the target company's stock rises sharply but lingers at a level slightly below the offer made. As an example, take the recent buyout offer for Yankee Candle (NYSE: YCC ) . Before the offer, Yankee shares were trading in the high $20s. The buyout offer was for $34.75 per share, and immediately after the announcement, the stock rose to between $33 and $34. The difference between the buyout price and the trading price can be explained by two factors. First, there is a lag between the time a buyout is announced and the time investors receive the actual cash payment, which, in the case of Yankee, is projected to be early next year. Second, there is always at least a small risk that the merger will not go through, in which case the stock may fall back to its pre-announcement levels. If the merger goes through, however, then you get to pocket the difference. Although that's a small profit, it may far exceed the returns you would get from other investments on an annualized basis.
Stock buyouts are a bit more complicated. For instance, last month, the Chicago Mercantile Exchange (NYSE: CME ) proposed a merger with the Chicago Board of Trade (NYSE: BOT ) . The terms of the merger would give CBOT shareholders just over three shares of CME for every 10 shares of CBOT they hold. The prices of CBOT shares rose sharply on the announcement; yesterday, CBOT shares closed at about $151, while CME shares were at $512. To use merger arbitrage for a potential profit, you would buy 10 shares of CBOT and sell three shares of CME. The short sale would give you a total of $1,536 in proceeds, while buying CBOT shares would only cost you $1,510. If the merger goes through, you'll receive three CME shares, which you can use to cover your earlier short sale.
It's important to understand that merger arbitrage is far from risk-free. Before a merger can take place, there are several things that the companies have to do. Regulatory agencies may have to approve mergers involving companies in certain industries, and if the proposed merger raises antitrust concerns, then the Department of Justice may review the terms of the merger and its effect on the market segment in which the companies do business to determine whether the merger will have anti-competitive consequences that run contrary to antitrust laws. For cash mergers, the acquiring company must secure enough financing to pay target shareholders. Overall market conditions can also change, making what originally would have been a profitable combination no longer viable. Last spring, investors in salon operator Regis (NYSE: RGS ) found that out the hard way when potential acquirer Alberto-Culver (NYSE: ACV ) backed out of merger talks. Although companies usually work hard to overcome these obstacles, it only takes one failed merger to wipe out the profits of several successful deals.
The lure of easy money is what draws investors to seek profits from arbitrage opportunities. As long as you understand the risks involved, looking closely at proposed mergers can help you discover ways to make good short-term returns on your investment.
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Fool contributor Dan Caplinger has dabbled in merger arbitrage, with both successes and failures. He doesn't own any shares of companies mentioned in this article. The Fool's disclosure policy is risk-free.