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The Influence Of Merger Arbitrage On Successful Takeover Finance Essay

INTRODUCTION

Arbitraging in the financial market is theoretically assumed to be riskless and without a need for capital. However, in reality, an arbitrage position involves the use of capital and has good traces of risk in it (Shleifer and Vishny, 1997). Such is the case of Merger arbitrage. Merger arbitrage is a risky strategy and often referred to as risk arbitrage. Subsequent to the announcement of a possible takeover, a merger arbitrageur buys into the target company with an ambition to make a profit from the takeover process. According to Cornelli and Li (2002), arbitrageurs take long positions in the target stock in a cash offer deal, with the hope that the takeover will go through. Furthermore, in a merger attempt involving stock swap deal, the arbitrageurs take a long position in the target firm’s stock with an offsetting short position in the acquiring firm’s stock (Branch and Yang, 2006b, Officer, 2007). In such deals, arbitrageurs could also short sell the acquiring company by borrowing shares with the hope of repaying them later with lower cost shares.

Mitchell and Pulvino (2001) argue that in a successful merger, the arbitrageur captures the spread. Conversely, the arbitrageur incurs a loss in a failed merger. According to them, such loss is usually much greater than the profit obtained if the deal is successful. However, Branch and Yang (2006b) contends that in the case of a takeover failure, the holding period performances of the target firm’s and the acquiring firm’s stocks in each long and short position (rather than the spreads) determine the return (positive or negative) on the risk arbitrage transaction.

In the last two decades, mergers and acquisition has received much empirical attention in financial studies although not much in the area of merger arbitrage. The first major study on merger arbitrage can be attributed to Ivan Boesky in 1986. More recently however, the arbitrage role in corporate takeover has researched into. Researchers have found evidence of risk arbitrage in merger attempts. For instance, Hsieh and Walking (2005) in their research found a positive relationship between the probability of a deal success and arbitrage holding i.e. a change in arbitrage position is imperative to deal success, bid premium and arbitrage returns.

Furthermore, several researches have gone into the determinant of the profitability of merger arbitrage. In the study of Jindra and Walkings (2004), arbitrage spread was found to be significantly related to bid premium, pre-offer run-up, target managerial attitude about the offer, and the existence of rumors about the offer. Similarly, the profitability of merger arbitrage, according to Branch and Yang (2006a), depends on two considerable factors: (1) the spread between the offer price and the market price of the target firm’s stock and (2) the probability of merger success. However, Baker and Savasoglu (2002) infer that abnormal returns around merger announcement are influenced by the target firm size and merger completion risk.

Apart from the influence of merger arbitrageurs in the financial market, Branch and Yang (2003) have suggested that the payment method in a merger deal also determine the success or otherwise of the merger. They proposed that cash payment option enhances the chances of success of a merger deal, compared with a deal with stock payment (stock swap). They also suggest that a collar offer deal is a better deal than the stock swap in terms of success prediction of an acquisition process. Interestingly, Hsieh and Walking (2005) reported that risk arbitrageurs purchase more target shares in collar offers than in cash and stock offer.

However deep researches on merger arbitrage are, major empirical works have been carried out on takeover deals in the United States. I intend to investigate evidence of merger arbitrage in the UK takeover deals and find its consistency with various evidences from the United States. Moreover, the question of how quick the arbitrageurs take position before abnormal returns wane and the impact of transaction cost on profitability of a risk arbitrage position have not been critically examined in recent researches. This research will examine the responsiveness of risk arbitrageurs to merger announcements and the effect of transaction cost on arbitrage position in the UK Market. This is relevant to understand how efficient the market for corporate takeover is and whether or not it is futile to take an arbitrage position in a merger attempt.

RESEARCH QUESTIONS AND OBJECTIVES

The primary role of any capital market is the allocation of financial ownership of the economy’s capital. The efficient market should therefore fully reflect in prices, all available information (Fama, 1970). However, because capital markets are never so perfectly efficient, the arbitrageurs seize opportunities to profit in the market(s). In the US market for corporate takeover, evidences of risk arbitrage have been found in many researches. However, in lieu of the discourse above, this research will examine the responsiveness of risk arbitrageurs to merger announcements and the effect of transaction costs on arbitrage profitability in the UK market for corporate control. This research therefore attempts to answer the following question:

How quick is the arbitrage position taken before the abnormal returns vanish?

Does transaction cost significantly deplete arbitrage holding during merger attempt?

RESEARCH METHOD

This study will use mergers and acquisition data sourced from Thomson One Baker. The sample to be drawn shall comprise of at least 100 target firms in successful takeovers spanning over a period between 2000 and 2007. Also, daily stock data for the sample of target firm will be drawn from yahoo finance. The proxies for the risk free rates are three months Treasury bill yield from 2000 to 2007 (Data to be extracted from Bank of England).

These data will be used to construct a time series returns on equal and value weighted merger arbitrage portfolio and in turn be benchmarked against the CAPM and Fama and French (1993) three factor model.

TIME SCALE

Project Length:

Duration of Project (months)

4 months

Proposed Start Date

May 5, 2010

Project Plan:

Milestone No.

Target Date

Details

1.

5th Apr – 5th May 2010

Dissertation proposal writing;

Dissertation discussion with Supervisor.

2.

4th Jun – 18th Jun 2010

Writing of introduction.

Extensive literature search and review.

3.

21st Jun – 25th Jun 2010

Review with Supervisor and modifications/improvement.

4.

28th Jun – 2nd Jul 2010

Reading/ preparation of methodology and models to answer research questions.

5.

5th Jul – 8th Jul 2010

Discussion of methodology, models and data with Supervisor.

6.

9th Jul - 19th Jul 2010

Data sourcing and Analysis.

7.

20th Jul – 30th Jul 2010

Application of models/methods.

Results and discussion

8.

2nd Aug – 6th Aug 2010

Evaluation of models and results by supervisor.

Adaption of the corrections and observation into the results.

9.

9th Aug – 13th Aug 2010

Writing the summary and conclusion.

Collating and attaching the appendixes

10.

16th Aug – 20th Aug 2010

Updating the literature review and introduction.

Writing the abstract.

11.

23rd Aug – 27th Aug 2010

Final Review with Supervisor.

Proof reading, correction and final updating.

12.

30th Aug – 31st Aug 2010

Printing and Binding.

13.

1st Sep 2010

Submission of Dissertation.

Gantt chart:

Research Details ( Progress )

Months

1

2

3

4

Dissertation proposal writing;

Dissertation discussion with Supervisor.

Writing of introduction.

Extensive literature search and review.

Review with Supervisor and modifications/improvement.

Reading/ preparation of methodology and models to answer research questions.

Discussion of methodology, models and data with Supervisor.

Data sourcing and Analysis.

Application of models/methods.

Results and discussion

Evaluation of models and results by supervisor.

Adaption of the corrections and observation into the results.

Writing the summary and conclusion.

Collating and attaching the appendixes

Updating the literature review and introduction.

Writing the abstract.

Final Review with Supervisor.

Proof reading, correction and final updating.

Printing and Binding.

Submission of Dissertation.

RESOURCES

Resources needed for the literature review are quality journal sourced from variety of business databases available online through the University of Leeds library website. Merger and Acquisition data are sourced from Thompson one Banker database and are freely accessible through the university library website. Other resources needed to complete this research are not far-fetched as no extra cost is envisaged throughout the period of the research.

BAKER, M. & SAVASOGLU, S. 2002. Limited arbitrage in mergers and acquisitions. Journal of Financial Economics, 64, 91-115.

BRANCH, B. & YANG, T. 2003. Predicting Successful Takeovers and Risk Arbitrage. Quarterly Journal of Business & Economics, 42, 3-18.

BRANCH, B. & YANG, T. 2006a. Merger Deal Structures and Investment Strategies. Journal of Alternative Investments, 9, 8-23.

BRANCH, B. & YANG, T. 2006b. A test of risk arbitrage profitability. International Review of Financial Analysis, 15, 39-56.

CORNELLI, F. & LI, D. D. 2002. Risk Arbitrage in Takeovers. Rev. Financ. Stud., 15, 837-868.

FAMA, E. F. 1970. Efficient Capital Markets: A Review of Theory and Empirical Work. The Journal of Finance, 25, 383-417.

FAMA, E. F. & FRENCH, K. R. 1993. Common risk factors in the returns on stocks and bonds. Journal of Financial Economics, 33, 3-56.

HSIEH, J. & WALKLING, R. A. 2005. Determinants and implications of arbitrage holdings in acquisitions. Journal of Financial Economics, 77, 605-648.

JINDRA, J. & WALKLING, R. A. 2004. Speculation spreads and the market pricing of proposed acquisitions. Journal of Corporate Finance, 10, 495-526.

MITCHELL, M. & PULVINO, T. 2001. Characteristics of Risk and Return in Risk Arbitrage. The Journal of Finance, 56, 2135-2175.

OFFICER, M. S. 2007. Are performance based arbitrage effects detectable? Evidence from merger arbitrage. Journal of Corporate Finance, 13, 793-812.

SHLEIFER, A. & VISHNY, R. W. 1997. The limits of arbitrage. Journal of Finance, 52, 35-55.

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