Extensions of the Merger Arbitrage Risk Model

Abstract

A traditional VaR approach is not suitable to assess the risk of merger arbitrage hedge funds. We recently proposed a simple two- or three-state model that captures the risk characteristics of the deals in which merger arbitrage funds invest. Here, we refine the model, and demonstrate that it captures merger and acquisition risk characteristics using over 4000 historical deals. We then measure the risk of a realistic sample portfolio. The risk measures that we obtain are consistent with those of actual hedge funds. Finally, we present a statistical model for the probability of success and show that we beat the market in an out-of-sample study, suggesting that there is a potential “alpha” for merger arbitrage hedge funds.

Keywords: Merger arbitrage, risk measurement

JEL Classification: C