Events Trader # 12: A risk arbitrage play for summer

28th July 2009

A risk arbitrage play for summer and an update on Eastern Europe

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Welcome back!

Summer is in full swing, everyone's on holiday and the markets are still trying to figure out what the future will hold. Will the green shoots of recovery turn into beautiful blossoms, or will the recession wreak havoc in the autumn? No one knows for sure and the result of this uncertainty is a pretty volatile equity market, which swings up and down on low volume.

While we wait for more information to help us divine the future path of the economy, I think it's a good idea to look for trading opportunities that will deliver us gains regardless of the direction the markets will take in the next few weeks. And that's why I've tracked down another risk arb play for you.

The trade

Back in April, Oracle (US: ORCL) announced an all-cash bid for Sun Microsystems (US: JAVA) for $9.50 a share. The deal was driven by Oracle's desire to consolidate its position in the software industry and to get its hand on the Java operating system and MySQL database. Oracle also pre-empted a possible bid by IBM, which was also keen to bid for Sun Micro.

The deal is subject to the usual approval by Sun Micro shareholders and the Justice Department, and is expected to close by the start of September. As of Monday's close, the shares are trading at $9.24, providing $0.26 profit, or 2.8%.

The story so far

Three developments are worth mentioning:

1. Approval of the takeover by Sun Micro shareholders happened on July 16th. It was approved by 62% of the shareholders, clearing the way for the bid to go ahead.

2. Sun's latest set of results, published on July 14th, came in below hopes. Sun reported a net loss of six cents per share versus analysts' expectations for a loss of two cents per share. The company also warned that the fourth quarter, from July 2009 to September 2009 will be worse than expected. Sun expects to lose 24-34 cents per share. This doesn't have any relevance if the bid goes ahead. But it does increase the risk that if the bid is blocked, the stock could fall more.

3. The most important development regards the fact that the US Justice Department has extended its antitrust (competition) review, and has asked the relevant parties to provide extra information. Oracle issued a statement saying that this extended review would not delay the planned completion of the bid, which is still expected to close by the 1st of September.

The maths

In my view, the risk of a delay is quite high. Past precedents suggest the date could be set back by two to four months. But even with a delayed date, the opportunity is quite interesting and worth playing. Here's why.

As you know the bid is at $9.50, with the stock trading at $9.24, providing an absolute profit of 2.8%. Let's assume that the bid is delayed by four months, until the end of December. In this case, the annualized return will be 6.7% (2.8 * 12/5). But I suspect that the completion date would be delayed perhaps until the end of October, in which case the annualised return would be a more respectable 11.2%. Of course, if it closes as expected next month, your annualized return will be more than 30%. And let's not forget that your return will not be correlated to the market, meaning that your return will be the same whether the market rises 20% or falls 20%.

How to play it

This is how I think this story should be played. Buy 50% of your overall position now and the other 50% if and when the merger is delayed, at a lower price (probably between 2-3% lower). This way, you still make money if the merger goes ahead, but you still have some ammunition if the bid is delayed and the stock falls on the news. If the merger is delayed then I expect there could be a fall in the stock of 2-3%, and you could use this to increase your yield.

The risks

The main risk here is that the Justice Department blocks the deal on antitrust grounds. In my opinion this would be very extreme, and has a very low chance of happening. Before a bid is formalised, the bidding company does all its due diligence, so that surprises don't emerge during the bid period.

In this case, if the merger is blocked than you can expect Sun Micro stock to fall significantly, especially as the set of results announced was not good. Judging by the stock price before the bid was announced, you can expect it to fall by between $6 and $7.

But I think it's much more likely that the bid is delayed - and as you've seen, this could provide us with an opportunity to buy in cheaper.

The other risk is currency risk for anyone not buying in dollars. This story is subject to a possible delay and this does mean that the currency hedging is more complex. The usual way in which you can hedge your currency, would be to sell dollars forward, which can be done through your broker or even through your high street bank.

Because of the peculiar situation of this bid, to be on the safe side I would suggest to hedge your currency exposure until the end of December. In this way, if the bid is delayed your currency risk will still be covered. The only slight snag is that it will take you a bit longer to convert your gain but don't worry too much, because if you have covered your currency until December and the bid closes as expected in one month, then you can still recycle your dollars into another risk arb position which I will try to find for you.

As a possible alternative to forward currency sales, you could always try to hedge using a currency spread bet, by selling an equal amount of dollars to your position. In this way you might be able to hedge your currency risk until the bid ends.

One more thing

A couple of weeks ago I received an interesting question from a subscriber who asked if these risk arb strategies could be successfully traded using spreadbetting or contracts for difference (CFDs) for both sides of the portfolio, not just the short side.

Here's my take on that. The first problem is the financing cost. As you know, risk arb strategies are ranked according to the absolute and annualized return they produce. The introduction of financing cost complicates the calculation of the return, and the return will vary significantly depending on these costs.

This figures also provides the return on your capital invested. For example if you buy $10,000 of Sun Micro, you will make roughly $280 or 2.8%, by the time the bid closes. But if you buy on margin using CFDs or spread betting, you will be charged interest on your open position. This will affect the profitability of the trade depending on the financing costs.

For example, if you are charged 5% a year (usually it is LIBOR +, but this will complicate matters even further) to keep your long position open, this will affect your annualized return. In our case, if the bid closes by December, then your 6.7% will be reduced to a 1.7% return.

The second, bigger problem, is more subtle. Sometimes to take part in a merger or a cash bid you need to be able to physically tender the shares to the bidder to receive the agreed price (your broker will do it for you). If you are long through a CFD or a spread bet you may not be able to do so.

This also introduces some form of "basis risk" this is the problem that the market price could be higher or lower than the bid price, or that the market price will not converge to the bid price by the time of the end of the offer. For example, Sun Micro could stay at $9.24 until the last day prior to the closure of the bid. If you own stock, you can tender them and receive the $9.50. But if you have a CFD you won't have made any money. Sometimes the stock stays listed after a bid is finished, so this could be a significant risk of playing risk arb strategies with CFDs. In all the three strategies that we have tipped already, MRK-SGP, WYE-PFE and JAVA, the target stock is expected to stop trading once the bid is over.

Please do consider your own circumstances and these risks when deciding how to play a risk arbitrage strategy. I will stick to explaining and playing the long side through cash purchase, because it will provide with a simple and comparable rate that everyone can achieve.

An update on eastern Europe: Lithuania

One last thing. Today it was revealed that preliminary readings suggest that Lithuania's economy shrunk by a 22.4% in the second quarter. As you may remember, we discussed Latvia's economy (Lithuania's neighbour) in a bearish note a few weeks ago.

Over the last few weeks everything has gone quiet and things are rolling on. But as you can see, the underlying problems remain in the region, and the risk of a devaluation and possible domino effect is still very much present. It's hard for us to imagine just how catastrophic a drop of 22.4% in GDP is, and I think sooner or later people will start to riot to demand better and less painful economic policies. And one way to relieve the economic (not to mention political) pain and to restart the economy would be to devalue the currency.

Last week Swedbank, one of the largest Swedish banks, and one of the most exposed to the Baltic region, reported a loss for Q2 and said that 54% of mortgage loans arranged in Latvia (that's right more than half) is in negative equity, with the value of the loan exceeding the value of the property collateral.

Let's wait for further developments - and be ready to act once the summer holiday is over!

As usual I welcome any questions or ideas that you might have, please e-mail me at my usual address eventstrader@f-s-p.co.uk.

Riccardo Marzi

Events Trader

Your capital is at risk when you invest in shares, never risk more than you can afford to lose. Some shares recommended may be denominated in a currency other than sterling. The return from such shares may increase or decrease as a result of currency fluctuations. Please seek independent personal advice if necessary.

Figures are calculated using the closing mid-prices on the date on which shares are first recommended. All gains are gross, and returns will be affected by dividend payments, dealing costs and taxes. Past performance and forecasts are not reliable indicators of future results.

Profits from share dealing are a form of income and subject to taxation. Tax treatment depends on individual circumstances and may be subject to change in the future. Editors or contributors may have an interest in shares recommended.

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