Sometimes, a bargain price on a stock seems to offer investors free money. If you don't understand the risks involved, though, attractive stocks can burn you.

Welcome to the world of merger arbitrage
That phenomenon may be most evident in stocks involved in pending mergers.

To cite one example, Oracle (NASDAQ:ORCL) recently agreed to buy out Sun Microsystems (NASDAQ:JAVA). The deal calls for Oracle to pay Sun shareholders $9.50 per share in cash.

But right now, you can buy Sun shares for a lot less than $9.50. Last Friday, the shares briefly traded below $9 before bouncing back. Given that the companies have said they expect the deal to be completed sometime in the next few months, earning what represents more than a 5% return looks attractive.

The Oracle/Sun deal has gotten a lot of attention lately, but it's definitely not the only opportunity for investors to try to cash in on merger arbitrage opportunities. Below are some of the other deals currently pending:

Target/Acquirer

Merger Price/Value

Current Share Price

Estimated Closing Date

Potential Return

Wyeth / Pfizer (NYSE:PFE)

$47.96

$45.03

Nov. 30

6.11%

Schering-Plough / Merck (NYSE:MRK)

$26.07

$24.56

Dec. 31

5.80%

Wind River Systems / Intel (NASDAQ:INTC)

$11.50

$11.46

Sept. 30

0.35%

Live Nation / Ticketmaster

$6.82

$6.56

Sept. 30

4.01%

Foundation Coal / Alpha Natural Resources

$28.79

$28.41

Dec. 31

1.34%

Sources: ArbitrageView.com and company press releases. Merger value represents current value of cash and stock offered to target shareholders. Current share prices taken from Yahoo! Finance as of 6/26/09.

Before you jump in on any of these stocks, don't kid yourself -- this isn't free money. Merger arbitrage -- trying to capitalize on the difference between a company's current share price and the price at which it'll soon be bought out -- involves a substantial amount of risk, for what amounts to a relatively small reward.

What can go wrong, does ... sometimes
When it comes to prospective mergers, all sorts of things can make a deal go sour:

  • Hostile management. In friendly mergers, such as the Sun/Oracle deal, management has typically already agreed to the terms of the merger, often before the news is made public. But when one company makes a hostile bid for another, the target's management may take steps to "protect" the company from being taken over -- even though many shareholders may actually prefer to take the deal.
  • Shareholder approval. Even if a target's management agrees to a buyout, shareholders typically have to approve the deal. You might think that the opportunity to reap a quick profit would always convince shareholders to accept a merger, but some longtime shareholders may prefer the potential for larger rewards in the future, rather than a quick but small payday right away.
  • Problems with regulators. Depending on the companies involved, mergers may require regulatory approval from a number of different sources. For instance, one reason why Sun shares dropped Friday was that the Justice Department requested more time to look at the merger rather than granting immediate approval. Despite assurances from attorneys involved with the merger that the request would not delay the merger, this is a good example of how even the slightest bit of bad news can spook shareholders.

The consequences of a failed merger can be dire. Witness Electronic Arts (NASDAQ:ERTS) and its aborted takeover bid for Take-Two Interactive (NASDAQ:TTWO). In February 2008, EA offered $26 per share to buy out Take-Two. Take-Two's board never accepted the bid, and after a tender offer made directly to shareholders failed to generate enough support, EA ended its buyout negotiations last September.

When EA announced it was ending talks, Take-Two's shares dropped by 24%, costing investors more in one day than they might have made had the merger gone forward. To add insult to injury, Take-Two shares have dropped even more precipitously since then. With shares now going for $9.50, shareholders can only look back with regret at the decision.

Proceed with caution
Of course, all investing involves risk. Even though buying shares of a potential merger candidate isn't risk-free, that doesn't mean it's automatically a bad investment. Just make sure that you understand exactly what could go wrong. And before you buy shares, demand a big enough potential return to compensate you adequately for the risk you're assuming.

More on great profit opportunities:

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Fool contributor Dan Caplinger has tried merger arbitrage in the past, with mixed success. He doesn't own shares of the companies mentioned in this article. Take-Two Interactive is a Motley Fool Rule Breakers selection. Electronic Arts is a Motley Fool Stock Advisor pick. Intel and Pfizer are Motley Fool Inside Value recommendations. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy never disappoints.