Deal Risk, Liquidity Risk, and the Profitability of Risk Arbitrage

52 Pages Posted: 24 May 2011  

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

Doina Chichernea

The University of Toledo - Department of Finance

Date Written: 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.

Keywords: Mergers and acquisitions, risk arbitrage, VIX, liquidity risk

JEL Classification: G34, G39

Suggested Citation

Wei, Jie (Diana) and Ferguson, Michael F. and Chichernea, Doina, Deal Risk, Liquidity Risk, and the Profitability of Risk Arbitrage (May 17, 2011). Available at SSRN: https://ssrn.com/abstract=1844405 or http://dx.doi.org/10.2139/ssrn.1844405

Jie (Diana) Wei

Government of the United States of America - Office of the Comptroller of the Currency (OCC) ( email )

400 7th Street SW
Washington, DC 20219
United States

Michael F. Ferguson

University of Cincinnati - Department of Finance - Real Estate ( email )

College of Business Administration
Cincinnati, OH 45221
United States
513-556-7080 (Phone)

Doina Chichernea (Contact Author)

The University of Toledo - Department of Finance ( email )

2801 W. Bancroft St, MS103
Toledo, OH 43606
United States

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