Events Trader #22: A new risk arb opportunity

6th October 2009

• A new risk arb opportunity
• Why options are better than covered warrants

Dear subscriber,

Last week we had a bit of a wobble from a market which is definitely looking toppy. I think we will see another 4-6 weeks of increasing volatility, and the market might take a breather. Then after that we'll stroll into December and quiet pre-Christmas trading.

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Last week, we were also lucky enough to see our latest strategy work straight away, which is why I sent out the update on Friday to tell you to take profits on the FTSE put options we bought. Had I known the correction was around the corner I would have tipped the October FTSE option and the resulting gain would have been even more spectacular than the 60% we managed in three days but sadly I'm just a trader, not a clairvoyant!

I also received an email from one reader asking if you can use covered warrants rather than options to implement last week's bearish strategy. As this is a very relevant question, I'll address it later on.

But first on to this week's trade it's another risk arb strategy. As you probably know by now, I like these because they provide a stream of steady positive returns in the current risky, toppy-looking market.

The deal: Xerox buys Affiliated Computer Services

Last week Xerox (US: XRX) announced the acquisition of Affiliated Computer Services (US: ACS) for $6.4bn in a mix of cash and shares. The merged company will be a global leader in enterprise for documents and business process management. Revenues for the combined group will total $22bn a year, of which $17bn will be recurring, with $300-400m a year in synergies.

Xerox has offered 4.935 in its own shares plus $18.60 in cash for each ACS share. The deal is expected to close in the first quarter of 2010 and is subject to the approval of the shareholders of each company, plus all the relevant authorities, which should not be a problem. Xerox will pay a dividend of 4.25 cents while this transaction is pending (at the end of the year). ACS does not pay a dividend.

ACS minority shareholders have also launched a lawsuit against the current board of directors claiming possible breach in the fiduciary duty of the board relating to the acquisition of ACS. The ACS chairman pledged his 43.6% stock in favour of the merger; the claimants also say that ACS was priced at $51 a share in April, and so the acquisition does not fully reflect the value of the company.

You shouldn't be put off by this lawsuit, as it might force Xerox to sweeten the proposed terms and is unlikely to result in the termination of the merger. As we will be long of ACS stock, any positive ruling from this lawsuit is likely to be in our favour. In essence, this is just a dispute between the minority shareholders and the majority shareholder who also happens to be the chairman of the company.

If you were to ask me to put a figure on it, I reckon this means that the risk of the merger failing is very low (less than 10%, say). The chance of us making the current premium is, I'd estimate, 70%, and there's a remaining 20% chance that the terms of the deal are revised in our favour, so that we make even more money. This potential upside is the reason I think it's worth playing this risk arb strategy.

The maths

Xerox closed at $7.44 (on Monday), and will pay a 4 cents dividend at the end of the year, while ACS closed at $52.26 and does not pay a dividend.

The equation is as follows:

4.935 * (US:XRX 0.04) + $18.60 US:ACS = profit

or

4.935 * (7.44 0.04) + 18.6 52.26 = $2.859 = 5.47% ($2.859 / $52.26)

The merger will take effect during the first quarter of 2010, so assuming a worst case scenario of a completion date at the end of March, the annualized yield will be 10.94%. Bear in mind that if the merger concludes before that date your annualized yield will increase, but the overall profit will stay the same.

The strategy

The strategy is the usual one. Buy shares of ACS, and short shares of Xerox. For every 1,000 ACS shares you buy, you should short 4,935 shares of Xerox. This way, you are set to lock in the return and your portfolio will be hedged (in other words, it doesn't matter if the overall market rises or falls, your return will be the same), and run the holdings until the merger completes.

As usual you can buy multiples or fraction of the suggested 1,000 shares, but always remember to keep the ratio constant, or else the value of your short or your long will not converge and you will not be able to make as much money as expected.

The best way to make the trade is to purchase the long side of the trade - the ACS shares in this case - using a normal broker. The short bit of the trade is best executed through spread betting. The relevant ratio for spread betting is $49.35 per point per 1,000 ACS shares you own (or $4.94 per cent per 100 shares).

Please look at my earlier notes on risk arb (in Issue 3, available on the Events Trader archive, password: Trophy) where I explain in detail the reasons and most importantly the risks in doing such actions.

The risks

The main risk here is the news relating to the recent lawsuit launched by the minority shareholders of ACS. In my view the main risk is a positive one it's possible that the terms of the merger are improved for ACS shareholders, and I do not think it will lead to a cancellation of the deal. Nevertheless it remains a risk (even if it is in your favour) and so you should be aware of it.

The other main risk as always - is the currency risk. These shares are dollar denominated, so you risk that between now and in six months' time the value of the dollar might have moved by a reasonable amount against sterling. Please refer to my earlier note on Pfizer / Wyeth for ways to sterilize this particular risk (in Issue 3, available on the Events Trader archive, password: Trophy).

Among other risks, there's antitrust (or competition) risk, but the danger that the deal could be delayed or blocked because of such issues is also minimal. The risk that the merger could fail is also very minimal. And even if it were to do so, the two stocks should not move much, as before the deal was announced ACS was trading around $48, while Xerox was around $9. This fact also contributes to the attractiveness of the trade.

Update on Disney and Marvel

A few weeks ago we discussed the proposed takeover of Marvel by Disney. Unfortunately the deal has turned out to be a Mickey Mouse transaction with no chance to make a decent profit.

Just to remind you, the terms of the transaction were $30 + 0.745 Disney shares for each Marvel share. When I first mentioned it, I said to wait until the spread had opened to at least 3%. But currently, the offer values Marvel at $50.11 versus a market price of $49.37 or a 1.8% discount on the offer price.

This is too little for us to be bothered with, so for the moment we'll stay away and await developments.

Why options are better than covered warrants

Last week I received an interesting E-mail from one of the readers asking me if you could have used covered warrants rather than options to implement last week's FTSE-bearish strategy.

The simple answer is yes' but you have to take into account the following.

Usually options traded on the market (such as the one I suggested) are "cheaper" than the corresponding covered warrant, as they tend to trade with lower implied volatility. This is because an open market with lots of participants tends to have better pricing than a market that is dominated by a single market maker as is the case with a covered warrant.

The market maker also determines the price. This means that when the market swings in your favour the market maker usually lowers the implied volatility (and the price swings) so as to limit its losses. I can recall past examples where I personally saw the price of the underlying security move while the price of the covered warrant moved less because the market maker that issued the warrant kept the price firm.

If you're having difficulty following this, just look at it this way. An option is like playing poker, where your opponents are other people; whereas a covered warrant is like playing roulette, where your opponent is the house.

Having said that, covered warrants aren't all bad. You can buy a covered warrant right away, whereas you need a special account and special paperwork to operate with options. And sometimes the commission charged on purchasing a covered warrant is lower than the cost of purchasing the relevant options.

So if you aren't an active trader and seldom use options, you might well want to consider covered warrants as long as you can get the same expiry date as the option; or, if taking into account the commission that you have to pay, the covered warrant gives you a better deal. One last issue is the fact that covered warrants generally have longer expiry and this makes them quite expensive.

Things change completely if you want to sell options and earn the volatility premium. In this case you can only use traded options, as you will not be allowed to short covered warrants. So far we have not used a strategy involving selling options, but at some point, I plan to introduce you to a volatility harvesting' strategy, which involves the sale of covered options. But that's for another day.

As usual I welcome your comments and suggestions - just e-mail me at 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. The share recommended is denominated in a currency other than sterling. The return from such shares may increase or decrease as a result of currency fluctuations. Spread betting is not suitable for everyone - ensure you fully understand the risks involved and never risk more than you can afford to lose. Prices can move rapidly against you and resulting losses may be more than your original stake or deposit. 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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