Abbot Labs & Alza Analysis
1. Risk arbitrage is an investment technique that occurs after a merger has been announced. Following this, the price of the target firm usually increases but still may not rise to the price offered by the acquiring firm. Generally speaking, the spread is positive. It is intended to compensate investors for the time to completion and the risk that the merger will not be consummated. In the case of the Abbot Labs (Abbot) and Alza merger - where a stock deal is proposed, the strategy involves purchasing the stock of the target, while simultaneously shorting the stock of the acquiring firm. The position, i.e. how much is bought and sold, depends on the exchange ratio of the deal.
The inherent risk with risk arbitrage is that the merger does not proceed, and rather than the target company receiving the previous offer price, the stock plummets. Being long in this company will subsequently result in significant losses when the position is unwound. In addition to this, because the arbitrager forms their position based on the exchange ratio of the deal, any subsequent changes in this ratio after the transaction may also leave them exposed to potential losses.
Potential profits are realizable due to the fact that, as previously mentioned the target companies stock currently trades at a discount to the bid of the acquirer. A profit will be realized therefore if the merger eventually proceeds and a premium is received for the long stock.
2. [see exhibit 1 for calculations] Green Circle (GC) ensured that no more than 5% of their total fund capital was committed to the long side of any deal (Endnote 1), and considering the uncertainty of the deal Chris Smith, the founding partner further restricted the firm to committi ...