Definition
Risk arbitrage (or merger arbitrage) is the investment strategy of buying target stock after a deal announcement and tendering at expiration to capture the spread. In stock-for-stock deals, arbitrageurs typically short the bidder and go long the target on the deal-implied ratio.
Returns and risks
- If the deal closes as announced — arb captures the full spread
- If the deal price is raised — arb captures additional upside
- If the deal breaks — target stock typically falls back toward (or below) the pre-announcement price; arb takes a substantial loss
Position sizing
Sophisticated arb funds size positions using:
- Probability of completion — drawn from historical base rates by deal type
- Time to close — drives annualized return
- Downside on break — drives risk
Role in tender offer dynamics
Arbs often hold meaningful positions late in the offer period and can be the marginal tendering volume. Their willingness to take on risk provides liquidity for long-term holders who exit early.