How do I know this? I don’t, but that’s what the market is telling me. The current stock prices of Merrill Lynch (NYSE:MER) and Bank of America (NYSE:BAC) imply that either the market doesn’t believe the deal will happen, or it doesn’t believe it will happen on the current terms (with Merrill shareholders receiving 0.8595 share of BofA for each of their Merrill shares). Let me explain why. 

Is this free money?
If we are certain that the deal will be completed, there is an easy arbitrage profit to be made:

  • Buy 10,000 shares of Merrill Lynch at $20.26. Cash outflow: $202,600.
  • Sell short 8,595 shares of Bank of America at $27.86. Cash inflow: $239,457.

Net inflow = +$36,857
[I’m not accounting for dividends in this calculation.]

At the deal completion, you receive 8,595 shares of BofA in exchange for your Merrill shares, which you deliver to close out your short position. You no longer have any stock position, and you keep the $36,857.

Congratulations! You’ve just earned an 18% total return ($36,857/$202,600) over the period that culminates in the deal consummation.

Wiping out on a merger arbitrage
Before you get on the phone to your broker, I’m going to have to disappoint you. This type of arbitrage (known as “merger arbitrage” or “risk arbitrage”) is widely practiced by investment banks and dedicated hedge funds. As a result, the market is pretty darn efficient, and it rarely hands out a riskless 18% return. One long-term study found that the annualized return of a risk arbitrage strategy is less than 11%.

A return of that magnitude indicates the market is skeptical that the deal will go through. I know this from bitter experience, having made a failed bet this summer that Fortress Investment Group (NYSE:FIG) would complete its acquisition of Penn National Gaming (NYSE:PENN). The potential return in that situation exceeded 70% at times. Unfortunately, Fortress backed out of the deal, and I’m looking at a total loss on my option position.

Will they or won’t they?
In my opinion, the BofA/Merrill deal is going to close, but there’s a pretty decent chance the terms will be renegotiated in favor of Bank of America (terms can change -- remember that JPMorgan Chase (NYSE:JPM) was forced to up its initial offer for Bear Stearns from $2 to $10 to cinch the deal).

Alternatively, it's possible (though unlikely, in my opinion) that another bidder will surface and disrupt the process. I don’t think JPMorgan Chase or Citibank (NYSE:C) have the appetite for it, but some foreign banks such as Barclays might.

More Wall Street/Banking Foolishness:

If you’re tired of investing in ‘solid’ stocks only to find out they are wildly speculative, it’s time to focus on profitable businesses with bulletproof balance sheets with The Motley Fool’s Inside Value service. Try a 30-day free trial now!

Alex Dumortier, CFA, owns calls on Penn National Gaming, but has no beneficial interest in any of the other companies mentioned in this article. JPMorgan Chase and Bank of America are Motley Fool Income Investor recommendations. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.