Abott Case Study

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3. Positive excess returns are expected from risk arbitrage strategy due to the role a risk arbitrager plays and the risk that he takes on. (Larcker, D. and T. Lys, 1987, “An empirical analysis of the incentives to engage in costly information acquisition," Journal of Financial Economics 18, 111-126). In a risk arbitrage investment strategy, it has been researched that the investment has a historical successful rate of 97%. While the returns on a risk arbitrage trade is limited by the spread and the losses are technically unlimited, the high success rate brings about positive excess returns over the long run. Market efficiency will not prevent such profits from persisting as it has been shown, theoretically, by Cornelli and Li (Cornelli, F. and David Li, 2002, “Risk arbitrage in takeovers," Review of Financial Studies, 15, 837-68), that merger arbitrageurs might not have full information on the merger but increase the probability of the deal being successful by getting involved. Hence, the news of the merger arbitrageurs being an incomplete information to the public serve as a form of market inefficiency and by the time the public knows that the merger arbitrageurs have taken a position and the public moves in to take a position, the probability of deal success would have improved significantly. Research has shown that a risk arbitrage strategy will be successful in the long run.

4. The put option serves as a hedge against the falling price of Alza. For the put option to be “in the money”, Alza has to fall below the strike price of $40. For this put option trade to be profitable (and for the Alza’s downside risk to be hedged), Alza has to fall below $46.75 (including the put option cost and a small component of risk free rate). The put potentially reduces the risk of the position partially as it hedges against the volatility of Alza. However, it does not fully eliminate the risk as Abbott stock is not hedged. The purchase of the put option decreases the expected returns due to the cost of the option and risk free rate.