Abbott Labs

1110 Words Oct 10th, 2013 5 Pages
Risk Arbitrage: Abbott Labs & Alza

1) How does risk arbitrage work? What are the risks and opportunities associated with this strategy?

Risk arbitrage, or merger and acquisition arbitrage, is one of three types of arbitrage strategies. Two types of mergers are possible: a cash merger and a stock merger.
Cash Merger Opportunities
Acquirer proposes to purchase the shares of the target for a certain price in cash. Until the acquisition is completed, the stock of the target usually trades below the purchase price. An arbitrageur buys the stock of the target and makes a gain if the acquirer ultimately buys the stock.
Stock-for-Stock Merger Opportunities
Acquirer proposes to buy the target by exchanging its own stock for the stock of
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The number of Abbott shares shorted is then found by multiplying the number of shares of Alza purchased by the Announced Exchange Ratio of 1.2 ABT:1.0 AZA, which yields 312,000 shares of Abbott that are to be shorted.
Potential and Expected Returns
The bet’s “payoff” is reflected in the spread between the market values of consideration to be received in the deal (acquirer’s stock, cash) minus the market values of securities to be given up (target’s stock).

Gross Spread (Per Share) = Value to be Received in the Transaction - Stock Price of Target
= Value of Abbott Shares to be Received - Price of Alza
= (43.50 x 1.2) - 48.00
= $4.20

Gross Spread (Total) = (43.50 x 312,000 shares) - (48.00 x 260,000 shares)
= 13,572,000 - 12,480,000
= $1,092,000

Net Spread = Gross Spread (total) ± All Other Cash Flows from Investment
= Gross Spread - Margin Interest + Short Sale Rebate
= 1,092,000 - ((6.2% x 50% x 12,480,000 x (191/365)) + (5.6% x 13,572,000 x (191/365))
= 1,092,000 - 202,450 + 397,715
= $1,287,265

Potential ROI = Net Spread / Total Capital Employed
= 1,287,265 / ((50% x 13,572,000) + (50% x 12,480,000))
= 1,287,265 / 13,026,000
= 10.1%

Annualized Potential ROI = Potential ROI x (365 / Number of Days until Completion)
= 10.1% x (365/191)
= 19.3%

3) Why would you expect positive excess returns…

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