Here is an analogy to make it simpler to understand. You order a crate of 100 pink lemons at a cost of $100 in June from a wholesaler that will be delivered in July. You believe the demand for pink lemons will soon jump because of a series of outdoor concerts planned for July. As the weather heats up and the expected consumer demand for cool, refreshing pink lemonade increases, you’re able to contract with a local lemonade stand to sell your pink lemons for $120.
The announcement of a merger or acquisition will provide an expected closing date and indicate the offer price. As the offer price is generally higher than the share price of the day, we call this the takeover premium. An investor who believes there’s a strong probability in a deal closing can purchase the target company’s shares at the slightly discounted price and later sell the fully valued shares upon completion of the deal to generate a profit. Even smaller profits compound to generate a healthy total return when this process is repeated in a series of mergers and acquisitions.Article content
They also protect a portfolio from excess volatility. Their low correlation to equity and bond markets makes them an excellent diversifier with the ability to smooth out portfolio volatility. Merger arb strategies are designed to provide portfolio protection and smooth out performance. Each merger arb deal is idiosyncratic with a low correlation to other deals.Article content
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