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Deal Risk, Liquidity Risk, and the Profitability of Risk ArbitrageJie (Diana) WeiGovernment of the United States of America - Office of the Comptroller of the Currency (OCC) Michael F. FergusonUniversity of Cincinnati - Department of Finance - Real Estate Doina ChicherneaThe University of Toledo - Department of Finance May 17, 2011 Abstract: Previous research documents that risk-arbitrageurs earn positive abnormal returns. However, this research treats the sum of two risks, deal risk and liquidity risk, as a measure of deal risk alone. We employ a forward looking measure of liquidity risk – the VIX – and we show that arbitrageurs’ ‘abnormal’ returns are higher when liquidity risk is higher. Thus, observed risk-arbitrage spreads compensate arbitrageurs for liquidity risk and deal failure risk. We conclude that the risk in risk-arbitrage has been systematically underestimated. Finally, we document an interaction between deal risk (a technical risk) and liquidity risk (a market risk) which is consistent with the analysis of real options models.
Number of Pages in PDF File: 52 Keywords: Mergers and acquisitions, risk arbitrage, VIX, liquidity risk JEL Classification: G34, G39 working papers seriesDate posted: May 24, 2011Suggested CitationContact Information
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