Option Prices and the Probability of Success of Cash Mergers

Abstract

We study both theoretically and empirically option prices on firms undergoing a cash merger offer. To estimate the merger's success probability, we use a Markov Chain Monte Carlo (MCMC) method using a state space representation of our model. Our estimated probability measure has significant predictive power for the merger outcome even after controlling for variables used in the merger literature. As predicted by the model, a graph of the target firm's implied volatility against the strike price has a kink at the offer price, and the kink's magnitude is proportional to the merger's success probability.

Keywords: Mergers and acquisitions, Black and Scholes formula, success probability, fallback price, Markov Chain Monte Carlo, implied volatility curve, volatility smile

JEL Classification: G13, G34, C58