Characteristics of Risk and Return in Risk Arbitrage

Abstract

This paper uses a sample of 4,750 stock swap mergers, cash mergers, and cash tender offers during 1963 - 1998 to characterize the risk and return in risk arbitrage. For out-of-sample comparison, we also examine the risk/return profile for a sample of active risk arbitrage hedge funds during 1990 - 1998. Results from both samples indicate that risk arbitrage returns are positively correlated with market returns in severely depreciating markets but uncorrelated with market returns in flat and appreciating markets. This result suggests that returns to risk arbitrage are similar to those obtained from selling uncovered index put options. Although linear asset pricing models provide reasonable estimates of the excess returns in risk arbitrage, a contingent claims analysis that incorporates the non-linearity in returns provides a more accurate description of the risk/return relationship. After controlling for both the non-linear return profile and transaction costs, we find that risk arbitrage generates excess returns of 4% per year.

Keywords: Risk arbitrage, asset pricing, market efficiency

JEL Classification: G10, G12