EVT #7: Why risk arbitrage is a good route to solid returns

This week we'll discuss another risk arbitrage opportunity in the US market. This strategy is quite similar to the Pfizer-Wyeth story that we invested in a few weeks ago.

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Welcome back! This week we'll discuss another risk arbitrage opportunity in the US market. This strategy is quite similar to the Pfizer-Wyeth story that we invested in a few weeks ago (see Events Trader issue threefor more).

You might be wondering why I'm tipping another risk 'arb' story when we already have one in the portfolio. The answer is very simple. Risk arbs are a very good and relatively safe way to make money. Because they are relatively limited risk, they could even be used as a bond-like instrument in a portfolio.

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The yield might not seem particularly high. And you could argue that with recent volatility in the stock markets you could get a 10% return in a week if you picked the right one. But you are missing a very big point: risk.

For a start you don't compare the yield on these strategies with the stock market return. That's like comparing apples with pears. Because of the relatively limited risk involved, and the large sizes you can invest, a better comparison for the yields on risk arb strategies, is to look at the yields on government or corporate bonds.

I can tell you, for example, that investment banks and hedge funds compare these returns (for risk arb) with their cost of funding. If the former exceeds the latter, the strategy can be leveraged up to increase the return on your capital employed.

I will discuss these points in more details later on in the newsletter. But now, let's get our teeth into the meat!

The event

Pharma giants Merck (NYSE: MRK) and Schering Plough (NYSE: SGP) announced back in March that they will pursue a friendly merger.

I will spare you all the details about the combined size of the new company, the potential synergies, the strategic thoughts behind such a combination and the long-term outlook of the pharmaceutical markets, simply because we don't care and none of it matters to the success of this strategy.

All we need to know is that the merger is friendly. Both boards have approved the deal, so it has a very high probability of being completed.

In these situations the two companies also have pre-emptive talks with the relevant authorities to make sure that no hurdles will come up once the merger is announced.

The terms are as follows:

For each share of Schering Plough that you hold, you'll receive 0.5767 shares of Merck and $10.50 in cash. The deal is expected to close in the fourth quarter, so we will assume a closing date of 31-12-2009 to be on the safe side. Schering will pay 0.065 cents in quarterly dividends while Merck will pay 0.38 cents quarterly dividend.

On Monday, Schering Plough closed at $23.34; while Merck closed at $25.18.

The strategy

Here is what you do.

You buy 1,000 shares of Schering Plough and sell 577 shares of Merck. You can buy multiples or fraction of the quantities suggested but whatever you do please keep the ratio 1:0.577, so that the trade remains market neutral. Being market neutral simply means that your return on this strategy will not be affected by the way the market moves - i.e. the market could go up or down 20%, but you will still end up making the same amount of money.

The return you can expect (excluding commission) is around 6% for a six-month period, or around 12% if you annualise it. If you allow for a 1% commission to allow for opening, closing and carrying the position then the return is reduced to around 5% or 10% on an annualised basis.

The maths

If you buy 1,000 Schering for $23,340 and sell 577 shares in Merck for $14,530 now, then in six months' time you will have received two quarters' worth of dividends ($130) plus $10,500 in cash, plus 577 shares in Merck, which you can use to offset your short in the shares. Meanwhile, Merck will also have paid out $440 in dividends (577 * 0.38 * 2), which has to be subtracted from your profit (when you are shorting a share, you have to cover any dividends it pays over the period that you are shorting it).

Let's simplify this by using a mathematical formula:

1,000 SGP + Profit = 577 MRK dividend MRK + $10,500 + dividend SGP


Profit = 577 MRK dividend MRK + $10,500 + dividend SGP 1,000 SGP

=> Profit = (14,530 - 440 + 10,500 +130) 23,340 = $1,380

So your return is $1,380 / $23,340 = 5.9%

To explain where I got the values from:

$14,530 is the value of 577 MRK (at Monday's closing price of $25.18).

$440 is the dividend for two quarters in MRK ($0.38*2*577).

$10,500 is the cash component of the offer.

$130 is the dividend for two quarters, paid by SGP ($0.065*2*1,000)

$23,340 is the value of 1,000 SGP (at Monday's closing price of $23.34)

In a nutshell, your portfolio of 1,000 SGP and -577 MRK will grow from $23,340 now, to $24,720 in six months time a return of 5.9%.

How to make the trade

This trade can be set up using all major online brokers.

Remember to keep the ratio at 1 SGP: 0.5767 MRK or thereabouts, so that you will be market neutral. By doing this you will lock in your 6% spread return, which won't be affected by market movements (in other words, what you make on the long you will lose on the short and vice versa)

Buy the Schering Plough shares: just do this with your normal broker. Do not use spread betting, as the financing could eat away a lot of your margin. You should be able to execute this leg of the trade for as little as £10 commission.

Sell Merck shares: it's better to do this step with a spread betting account. The procedure to borrow stock is cumbersome and requires some scale (£300,000 plus). On top of this, some online brokers will not allow you to short shares for long periods of time.

Spread betting is an easy way to gain short exposure to a stock without all the time-consuming expense and hassle of actually borrowing the stock. If you use spread betting than the ratio becomes 1,000 SGP shares for $5.77 for each one cent move in MRK in other words, for every 1,000 SGP shares you buy, you need to sell MRK at $5.77 a point.

When you're spread betting please also ensure that:

the spread is not too wide or too far off the real market;

that you will be allowed to keep the position open for a long time sometimes you might be charged a rollover fee (in my case it was 6 cents a quarter);

that you will be required to pay only 100% of the dividend in Merck (sometimes a tax credit is generated and you might be required to pay more, but it is unlikely).

The main thing you have to consider here is that if the market moves higher, you will show an actual loss on your spread betting account. This means that you will be required to post additional capital to cover the loss. You'll be showing a profit on your long in SGP, but obviously, this will only be on paper until you close the position.

Once the merger is completed in the fourth quarter, then your 1,000 SGP shares will be converted into cash and 577 MRK. After that, you can simultaneously close the short in the spread betting account, and sell the MRK shares.

So what are the risks?

The main risk here is that the merger will fall apart or be blocked. This is an asymmetric risk. You can find a longer definition of this term in Events Trader issue three, but basically what it means is that you have a large chance of making a small gain, and a small chance of making a large loss.

However, because the merger is friendly and both boards have approved it already, the probability of it falling apart in my opinion is less than 1%. As I said before, mergers of this size are generally discussed with the relevant regulators before the announcement and all possible obstacles are usually dealt with before the market announcement.

What if the merger were to fall apart? Well, looking at where the shares were trading before the announcement, I reckon you could face a loss of 10% from your long position in SGP and probably 5% from your short in MRK.

The positive risk (i.e. the chance that you make more than you expected) is that the merger terms could be improved, or that another bidder joins the party. But the chance of either option happening is close tozero in this case.

You also run the risk that the merger is delayed and closes after the expected date of 31-12-2009. This is not a huge problem the amount of money you have locked in your spread will remain the same but it will be spread over a longer period of time, reducing your annualised yield. This risk can also pose problems if you have hedged your currency exposure, as you will need to extend the terms of the hedge.

Another risk is that the spread will widen after you have set up the trade, maybe as a result of a large order in one of the stocks or as a result of market volatility. In this case do not panic just hold on to your position and usually the market corrects itself in a matter of days.

Finally the last risk you carry which only applies if your assets are denominated in pounds and not in dollars is currency risk. The concern here is that by the time the merger closes the exchange rate between dollars and pounds or euros may have moved. This can either go in your favour or against you.

Because currency markets have been quite volatile lately, this could be the biggest risk you are faced with, but there are ways around it. The easiest way to hedge this risk is to sell dollars forward for delivery at the end of the year, or two months later to be on the safe side if the merger is delayed for any reason. You should be able to sell currency forward using your broker or even your high street bank, so please check which has the better offer.

Again, I discussed these risks in more detail in Events Trader issue three.

Why play this merger as well as Pfizer / Wyeth?

Why do I think this strategy is worth playing, given that we have a risk arb play in the portfolio already? Well, for one thing, there's simple diversification. If you play both MRK / SGP and WYE / PFE then you can diversify some of the asymmetric risk intrinsic with these strategies. In other words, if one merger fails, you shouldn't suffer too much, assuming the other one goes through.

Also with interest rates close to 0% and with six-month comparable bonds yielding around 2%, a 5% return is not to be sniffed at.

If you haven't already played the Wyeth / Pfizer trade, then be aware that the spread has already closed by 1.5%. So the Merck / Schering one would be the most profitable of the two if you are just starting now.

More on the risk profile of risk arb

Let's take a longer look at the difference in the risk profile between a risk arb and a long only strategy.

Basically, when you buy a stock (long-only strategy) you broadly have a 50% chance that the stock goes up and 50% chance that the stock goes down. If you wanted to be more precise, you could say that you have 10% chance that the stock will go up by more than 10% in a week, 15% chance that the stock will go up by between 5% and 10% in a week and 25% chance that the stock will go up between 0% and 5% in a week. The reverse would also be true for the remaining 50% chance of the stock going down.

The return that you might expect is similar to a normal-shaped probability distribution. This probability distribution is defined by two parameters: the mean (which can be assumed to be zero); and variance, which in our case is the value of the risk. The higher the variance, the higher the risk.


Image sourced from www.asp.ucar.edu

This chart above shows various probability distributions. The curve with the highest spike in the middle, is the 'safest' bet of the four curves. Most of the possible outcomes cluster around a central point, so the chances of having an unexpected outcome are low. Also, the extent of possible variance (or 'deviation') from the central outcome is limited.

On the other hand, the flattest curve represents a much riskier play. In this case, there is a very a wide range of outcomes, with the central outcome only slightly more likely than any other single outcome.

To put this into more practical terms: if you bought a stock and you made 10% in a week, for example, you would have been quite lucky, as the probability of such an event is only 10%. You had a much higher chance of making less than 10%, or maybe even a loss.

At the other extreme you have an event that happens with certainty, or with a probability of 100%. An example could be a time deposit, where you know the interest rate you will get in advance. At the end of the time period your return would be exactly what you expected, and there's no worry it won't be paid.

Risk arb strategies fall somewhere in between these two extremes, they have a more certain return than just buying a stock, but unlike a time deposit, they have a small probability of failing. In our case you have what I reckon is a 98-99% chance of making 8% in six months' time, so this risk profile makes them worthy of consideration.

Various factors affect the probability of failing. The main factor is whether the bid/merger is friendly or hostile; the second factor is competition issues. In my experience, the failure rate for big friendly mergers is below 1%. In fact, I can't remember any historical case of a friendly merger between two large companies that has been blocked, though that's not to say it hasn't happened, as most data on mergers focuses on the rate of success and failure after the actual deal has concluded.

As I mentioned above, investment banks and hedge funds compare the spread you can obtain from a risk arb strategy to their cost of funding. and if one is higher than the other they leverage up (i.e. borrow money to increase their returns on what they deem to be a strategy carrying little risk).

For example, say a spread yields 8%. Imagine a hedge fund trader with $1m and a cost of funding of 3%. He could set up the trade, and earn 8% on the $1m. But on top of this, he could borrow a further million and double his position.

The yield on the second million would be 5% (8% 3% cost of funding). However, his return on capital employed would be 13% (8% on the first million + 5% on the second borrowed million). This is the reason why hedge funds enjoyed spectacular returns in the period 2000-2007 it was simply by leveraging up on their positions.

An update on our bank bonds trade

A reader has made me aware of the fact that the Nationwide tier 1 bond that I tipped previously has a minimum size of £50,000, and not £1,000 as I had thought. I apologise for this I had originally selected a wide range of bonds to suit all sizes of trades, and had cut it down to three which I believed had the £1,000 nominal minimum trade.

However, do not despair, because there are literally hundreds of these bonds available. I would suggest that interested readers browse www.indexco.com. After a free registration, you can check for the bond that most suits your situation. You can find them by simply typing the issuer name in the left-hand side window. I discussed these bonds in more detail in the first issue of Events Trader.

As I'm touching on the subject, let me also update you on a couple of developments.

Firstly, banks are repurchasing these bonds in the market as they are still trading at distressed prices, and believe it or not, the banks can book the difference between the issue price and the price they buy them at, as profit.

Secondly, it is starting to become clear that in the event of a nationalisation these bonds will be required to shoulder some pain. There is even a risk that they might not be paid (although remember that before these securities are touched, ordinary shares have to be wiped out).

The big test will come soon when the banks report their results for the first half. If the results are good, then expect this type of security to keep rising. If the results are bad, I don't expect them to move much. But if the results are terrible, and there is talk again of further state support and possible nationalisation, then it is very likely that the prices will tank again.

This could provide another buying opportunity. But I don't really expect it to happen as I think that the banks will be allowed to earn their way out of their losses. As you know, they now have a state guarantee on their worst assets and the spread between assets and liabilities has risen dramatically (i.e. they pay savings rates at close to 0% and charge you closer to 4% or more for your mortgage).

Oh, and before I go last week I received a couple of emails from readers who wanted my views on bonds more generally and US Treasuries in particular. As I think that inflation could be set to rear its head at a time when various governments are issuing vast quantities of debt, I thought that this would make an interesting topic to cover next time.

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