Deal Risk, Liquidity Risk, and the Profitability of Risk Arbitrage
Jie (Diana) Wei
Government of the United States of America - Office of the Comptroller of the Currency (OCC)
Michael F. Ferguson
University of Cincinnati - Department of Finance - Real Estate
The University of Toledo - Department of Finance
May 17, 2011
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
Date posted: May 24, 2011
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