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Abstract:
This paper uses a sample of 4,750 stock swap mergers, cash mergers, and cash tender offers during 1963 - 1998 to characterize the risk and return in risk arbitrage. For out-of-sample comparison, we also examine the risk/return profile for a sample of active risk arbitrage hedge funds during 1990 - 1998. Results from both samples indicate that risk arbitrage returns are positively correlated with market returns in severely depreciating markets but uncorrelated with market returns in flat and appreciating markets. This result suggests that returns to risk arbitrage are similar to those obtained from selling uncovered index put options. Although linear asset pricing models provide reasonable estimates of the excess returns in risk arbitrage, a contingent claims analysis that incorporates the non-linearity in returns provides a more accurate description of the risk/return relationship. After controlling for both the non-linear return profile and transaction costs, we find that risk arbitrage generates excess returns of 4% per year.

Risk arbitrage, asset pricing, market efficiency

Abstract:
This paper uses a sample of 4,750 stock swap mergers, cash mergers, and cash tender offers during 1963 - 1998 to characterize the risk and return in risk arbitrage. For out-of-sample comparison, we also examine the risk/return profile for a sample of active risk arbitrage hedge funds during 1990 - 1998. Results from both samples indicate that risk arbitrage returns are positively correlated with market returns in severely depreciating markets but uncorrelated with market returns in flat and appreciating markets. This result suggests that returns to risk arbitrage are similar to those obtained from selling uncovered index put options. Although linear asset pricing models provide reasonable estimates of the excess returns in risk arbitrage, a contingent claims analysis that incorporates the non-linearity in returns provides a more accurate description of the risk/return relationship. After controlling for both the non-linear return profile and transaction costs, we find that risk arbitrage generates excess returns of 4% per year.

Risk arbitrage, asset pricing, market efficiency

Abstract:
As in previous decades, merger activity clusters by industry during the 1990s. One particular kind of industry shock, deregulation, becomes a dominant factor, accounting for nearly half of the merger activity since the late 1980s. In contrast to the 1980s, mergers in the 1990s are mostly stock swaps, and hostile takeovers virtually disappear. Over our 1973 to 1998 sample period, the announcement-period stock market response to mergers is positive for the combined merging parties, suggesting that mergers create value on behalf of shareholders. Consistent with that, we find evidence of improved operating performance following mergers, relative to industry peers.

Abstract:
This paper examines the trading behavior of professional investors around 2,130 mergers announced between 1994 and 2000. We find considerable support for the existence of price pressure around mergers caused by uniformed shifts in excess demand, but that these effects are fairly short-lived, consistent with the notion that short-run demand curves for stocks are not perfectly elastic. We estimate that roughly one half of the negative announcement period stock price reaction for acquirers in stock-financed mergers reflects downward price pressure caused by merger arbitrage short selling.

Mergers, Short-selling, Arbitrage, Price Pressure, Downward Sloping Demand Curves

Abstract:
We examine 82 situations where the market value of a company is less than its subsidiary. These situations imply arbitrage opportunities, providing an ideal setting to study the risks and market frictions that prevent arbitrageurs from immediately forcing prices to fundamental values. For 30 percent of the sample, the link between the parent and its subsidiary is severed before the relative value discrepancy is corrected. Furthermore, returns to a specialized arbitrageur would be 50 percent larger if the path to convergence was smooth rather than as observed. Uncertainty about the distribution of returns and characteristics of the risks limits arbitrage.

Abstract:
This paper examines the impediments to arbitrage in 82 situations between 1985 and 2000, where the market value of a company is less than the sum of its publicly traded parts. These situations suggest clear arbitrage opportunities and provide an ideal setting in which to study the risks and market frictions that prevent arbitrageurs from immediately forcing prices to fundamental values. We find that 30% of the situations terminate without converging. Furthermore, because of forced liquidation to satisfy capital requirements, we estimate that the returns to a specialized arbitrageur would be 50% larger if the path to convergence was smooth rather than as observed. Uncertainty about the distribution of returns and characteristics of the risks appear to be an important obstacle.

Abstract:
This paper presents clinically-based studies of two acquisitions that received very different stock market reactions at announcements one positive and one negative. Despite the differing market reactions, we find that, ultimately, neither acquisition created value overall. In exploring the reasons for the acquisition outcomes, we rely primarily on interviews with managers and on internally generated performance data. We compare the results of these analyses to those from analyses of post-acquisition operating and stock price performance traditionally applied to large samples.

We draw two primary conclusions. (1) Our findings highlight the difficulty of implementing a successful acquisition strategy and of running an effective internal capital market. Post-acquisition difficulties resulted because: (a) managers of the acquiring company did not deeply understand the target company at the time of the acquisition; (b) the acquirer imposed an inappropriate organizational design on the target as part of the post-acquisition integration process; and (c) inappropriate management incentives existed at both the top management and division level. (2) Measures of operating performance used in large sample studies are weakly correlated with actual post-acquisition operating performance.

Abstract:
A rapidly growing literature claims to reject the semi-strong form of the efficient market hypothesis by producing large estimates of long-term abnormal stock price performance subsequent to major corporate events. We re-examine three large samples of major managerial decisions, namely acquisitions, equity issues, and equity repurchases, and find little evidence of reliable long-term abnormal stock price performance for the three samples. The analysis shows (a) cross-sectional dependence of abnormal returns leads to inflated test statistics and (b) estimates of abnormal performance are small, and largely limited to small stocks, after accounting for the known mis-pricings of the model used to generate the results.

Abstract:
We study three cases in which specialized arbitrageurs lost significant amounts of capital and, as a result, became liquidity demanders rather than providers. The effects on security markets were large and persistent: Prices dropped relative to fundamentals and the rebound took months. While multi-strategy hedge funds who were not capital constrained increased their positions, a large fraction of these funds actually acted as net sellers consistent with the view that information barriers within a firm (not just relative to outside investors) can lead to capital constraints for trading desks with mark-to-market losses. Our findings suggest that real world frictions impede arbitrage capital.

Capital constraint, convertible bond, frictions, hedge funds, limits of arbitrage, liquidity, merger arbitrage, risk management, valuation

Abstract:
We study three cases in which specialized arbitrageurs lost significant amounts of capital and, as a result, became liquidity demanders rather than providers. The effects on security markets were large and persistent: Prices dropped relative to fundamentals and the rebound took months. While multi-strategy hedge funds who were not capital constrained increased their positions, a large fraction of these funds actually acted as net sellers consistent with the view that information barriers within a firm (not just relative to outside investors) can lead to capital constraints for trading desks with mark-to-market losses. Our findings suggest that real world frictions impede arbitrage capital.

Abstract:
We study three cases in which specialized arbitrageurs lost significant amounts of capital and, as a result, became liquidity demanders rather than providers. The effects on security markets were large and persistent: Prices dropped relative to fundamentals and the rebound took months. While multi-strategy hedge funds who were not capital constrained increased their positions, a large fraction of these funds actually acted as net sellers consistent with the view that information barriers within a firm (not just relative to outside investors) can lead to capital constraints for trading desks with mark-to-market losses. Our findings suggest that real world frictions impede arbitrage capital.

limits of arbitrage, capital constraint, valuation, risk management, liquidity, hedge funds, convertible bond, merger arbitrage, frictions

Abstract:
This paper presents clinically-based studies of two acquisitions that received very different stock market reactions at announcement one positive and one negative. Despite the differing market reactions, we find that ultimately neither acquisition created value overall. In exploring the reasons for the acquisition outcomes, we rely primarily on interviews with managers and on internally generated performance data. We compare the results of these analyses to those from analyses of post-acquisition operating and stock price performance traditionally applied to large samples. We draw two primary conclusions. (1) Our findings highlight the difficulty of implementing a successful acquisition strategy and of running an effective internal capital market. Post-acquisition difficulties resulted because: (a) managers of the" acquiring company did not deeply understand the target company at the time of the acquisition; (b) the acquirer imposed an inappropriate organizational design on the target as part of the post-acquisition integration process; and (c) inappropriate management incentives existed at both the top management and division levels. (2) Measures of operating performance used in large sample studies are weakly correlated with actual post-acquisition operating performance."

Abstract:
SUBJECT AREAS: Arbitrage, Capital markets, Commodity markets, Efficient markets, Finance, Hedging, Interest rates, Investment management, Reorganization, Risk management, Securities markets, Spinoffs.

CASE SETTING: New York, NY; finance; $12 million revenues; 5 employees; 1998-1999

Strategic Capital Management, LLC is a hedge fund planning to make financial investments in Creative Computers and Ubid. Creative Computers recently sold approximately 20% of its Internet auction subsidiary, Ubid, to the public at $15 per share. Ubid's stock price closed the first day of trading at $48, giving Ubid a $439 million market capitalization. Paradoxically, the parent's stock price did not keep pace with that of its subsidiary. At the end of Ubid's first day as a public company, Creative Computers' equity value was less than the value of its stake in Ubid. The market prices implied that Creative Computers' non-Ubid assets had a value of negative $79 million. The relative prices and ownership link between Creative Computers and Ubid suggests a potential arbitrage opportunity. To evaluate how best to exploit this investment opportunity, Elena King, the manager of the hedge fund, must understand the risks and expected returns associated with different long and short equity positions.

Teaching Purpose: To develop an understanding of how arbitrage acts to enforce the law of one price and to keep markets efficient. Also provides a venue to discuss the various real world market imperfections that can prevent arbitrageurs from immediately eliminating mispricings in equity markets. Best taught at the end of a capital markets module.

Abstract:
SUBJECT AREAS: Investment management, Pension funds, Portfolio management, Risk, State Government

CASE SETTING: 1998, U.S.

Considers the managerial decision faced by the state's treasurer in 1998. Until last year the South Carolina state pension fund (with over $17 billion in assets) was barred by the state constitution from investing in equities. After the constitution was amended, the state government had to decide how much to invest in equities, and what assets to choose. Using domestic and international data, the concepts of standard deviation, correlation, covariance, diversification, and risk are introduced. Additionally the case looks at the equity premium from a global setting. Covers two days, and will be used early in the Risk and Return module, just before the introduction of the CAPM.

Specific learning objectives of these cases include these:

To introduce the concept of risk and return in capital markets. Illustrates benefits of portfolio diversification.

Abstract:
SUBJECT AREAS: Capital budgeting, Capital costs, Capital markets, Financial services, Holding companies, Regression analysis, Valuation

CASE SETTING: 1997, U.S.

Ameritrade Holding Corp. is planning large marketing and technology investments to improve the company's competitive position in deep-discount brokerage by taking advantage of emerging economies of scale. In order to evaluate whether the strategy would generate sufficient future cash flows to merit the investment, Joe Ricketts, chairman and CEO of Ameritrade, would need an estimate of the project's cost of capital. There is considerable disagreement as to the correct cost of capital estimate. A research analyst pegs the cost of capital at 12%, the CFO of Ameritrade uses 15%, and some members of Ameritrade management believe that the borrowing rate of 9% is the rate by which to discount the future cash flows expected to result from the project. There is also disagreement as to the type of business that Ameritrade is in. Management insists that Ameritrade is a brokerage firm, whereas some research analysts and managers of other online brokerage firms suggest that Ameritrade is a technology/Internet firm.

Specific learning objectives of these cases include these: A two-day case to estimate the cost of capital that Ameritrade should employ in evaluating the proposed large investments in marketing and technology. The lesson plan builds on the prior cases in the Risk & Return module. Uses the capital asset pricing model to estimate Ameritrade's cost of capital. Focus is on CAPM variables such as the risk free rate, market risk premium, and beta. Students will use regression analysis to directly calculate the beta estimates. Arguments will be made as to which comparable firms (brokerage firms or Internet firms) should be used to obtain beta estimates.

Abstract:

SUBJECT AREAS: Capital structure; interest tax shields.
CASE SETTING: 1998; smokeless tobacco producer.


UST Inc., the dominant producer of moist smokeless tobacco, is planning a major change in capital structure via a debt-financed stock repurchase program. UST had been widely known for its conservative debt policy and high dividend payout. The proposed change in capital structure not only reverses a long-standing conservative financial policy, but also does so during a time period in which the business environment has become increasingly uncertain due to recent litigation and legislation developments.

The case provides the opportunity for students to analyze the value implications of a major change in capital structure policy: (1) introduction to capital structure policy, (2) calculate tax shields of debt financing, and (3) assess business and financial risks associated with a firm undergoing a recapitalization.

Abstract:
This article illustrates the use of event study methodology in securities fraud litigation, specifically SEC enforcement actions. It first outlines the legal basis for the use of financial economics in securities fraud law. Areas of securities fraud law where event study evidence may be relevant include the establishment of materiality and the estimate of damages (or disgorgement). The article then demonstrates how financial economics was used in five SEC enforcement actions including insider trading around a CEO replacement, insider trading in the target and the bidder around an acquisition, and a delinquent 13D filing. The article also serves as a primer in event studies for non -financial economists and lawyers.

Abstract:
SUBJECT AREAS: Optimal capital structure.

CASE SETTING: 1993, tobacco industry.

This case studies UST Inc., a very successful corporation that has no debt in contrast to comparable firms in the tobacco industry. The setting is 1993 when a new management team is about to take the helm from a chairman who has long opposed debt financing. The issue is whether the new management team should recapitalize UST Inc. in order to take advantage of interest tax shields. UST Inc. provides an excellent opportunity to apply optimal capital structure theory in a real setting. It should be taught soon after students have developed a basic understanding of textbook capital structure. The case allows students to determine the optimal capital structure for UST Inc., accounting for interest tax shields, bankruptcy costs, monitoring benefits of debt, and so forth. The case is also a good vehicle to indicate that we do not have an acceptable formula for calculating the optimal capital structure. I have taught UST Inc. in introductory MBA and executive MBA corporate finance classes. In MBA programs where cases are not taught in the introductory finance course, UST Inc. is a good case to start the capital structure module in the advanced MBA corporate finance class. It has also been successfully used in undergraduate finance classes.