(16) Event driven investment
Company AQ has offered to purchase all outstanding shares in company TAR. AQ is offering two AQ shares per TAR share. After the announcement AQ is trading at €50 and TAR is trading at €90. The risk-free rate is -1% annually. Which of the following positions may the hedge fund consider taking in order to hedge unwanted exposures?
A long position in out-of-the-money put options on equities The question is concerned with possible hedges in addition to the shorting of AQ which eliminates the risk associated with the value of AQ shares. We know that therisk of deal failure increases in very poor states of the market (though this effect is stronger for cash deals than for stock deals). Hence, we may want to take a position with positive payoff when market returns are substantially negative. This is what an out-of-the-money put option on the market does
When is a negative stub value an arbitrage opportunity?
A negative stub value is a real arbitrage when it is known that the parent will distribute its shares of the subsidiary and it's possible to short sale the subsidiary.
What is a fallen angel?
Downgrade from investment grade to speculative grade.
How do you hedge a merger arbitrage (Payment: Collar stock merger)
- Buy target - Trade options or delta hedge acquire stock
Company AQ has offered to purchase all outstanding shares in company TAR. AQ is offering two AQ shares per TAR share. After the announcement AQ is trading at €50 and TAR is trading at €90. The risk-free rate is -1% annually. What is the deal spread?
(2x50-90)/90=11,11%
How do you hedge this egyptian collar deal? (Merger arbitrage) - if AQ < 40 = 40 - If 40 < AQ < 60 = 1,2 shares of the AQ - If 60 < AQ = 72
- 1.2 Sell call strike 40 - 1.2 Buy call strike 60
What are the risks associated with trading on a negative stub value?
- The parent firm may not distribute the shares of the subsidiary even if the parent announces an intention to do so. - The parent can go bankrupt - The distribution can have a negative tax consequence - Short-selling the subsidiary can be costly, difficult, and risky.
How do you hedge a merger arbitrage (Payment: floating-exchange ratio stock, e.g. 100$ in AQ shares.)
-Buy target -Short acquirer during pricing period (not immediately)
What does a synthetic stub trade consist of?
-Long Parent Company -Long Put with strike X on Subsidiary -Short Call with strike X on Subsidiary If subsidiary ends below X we use the put to sell at X. If subsidiary ends above X our counterparty will use the call to buy from us at X. In any case we will sell at X
How can a company sell a subsidiary
1.To another company in a private divesture 2.To the public, which can be done in several ways: -Spin off -Split off -Carve out
1) Six existing shares entitle the holder to subscribe for one new share. Subscription price = 33 SEK per share Price the day before = 42,8 SEK What do you expect the share to open on the next day? What is the fair value price of the subscription right ? 2) The share closed at 41,1 SEK and the subscription right at 1,1Sek. - Which trades would you consider What are the expected profit What are the risk
42,8 = P_ex + rights P_ex = 6rights + 33 R = 1,4 and P_ex=41,4 2) Buy rights and use them for buying a share at the subscription price at 33. Simultanously, short the stock. Profit = 41,1-39,6=1,5 Not riskfree, because of volatility, but you will make 1,5 on average.
Price before offer = 140 Offer price = 200 Scania closed at a price of SEK 194.5 per share on February 24, 2014 (the first trading day after the offer was announced). What does this price say about the implied risk neutral probability of the transaction going through? You will need to make some assumptions. State these explicitly.
Assumptions: • Scania will trade at SEK 145 if the merger is not completed, a price which is slightly below the pre-announcement price of Scania "B", • there is a zero chance of completion at a price higher than SEK 200, and • the risk-free return from announcement to completion is 0. 194,5 = 200*P+145*(1-P) P = 90%
How do you make a synthetic long position?
Being long one share is equivalent to being long one call with strike X and short one put with stake X and holding X in cash -ignoring interest and dividends
How do you make a synthetic short?
Being long one share is equivalent to being long one put with strike X and short one call with stake X and loan X in cash - ignoring interest and dividends
How do you hedge this Travolta collar deal? (Merger arbitrage) - if AQ < 40 = 1,5 shares of AQ - If 40 < AQ < 60 = 60$ - If 60 < AQ = 1 share of AQ What can be the problems with the strategy?
Buy 1,5 put option at strike 40 Sell 1 call at strike 60 2) - The put and call options aren't available - The put and call options need to have the same expirations date as the merger goes through, but the problem is that you don't know the exact date. 3) You can't also hedge the position by using a delta hedge.
How do you hedge a merger arbitrage (Payment: fixed-exchange ratio stock, e.g. 2 acquire shares pr. target share
Buy target and short acquirer immediately
How do you hedge a merger arbitrage (Payment: cash)
Buy target and wait
How do you trade on spin offs and split offs?
Buy the subsidiary, because you think it's undervalued because of the spin-off or split-off. You hold the subsidiary until the full value is reflected. Initially, subsidiary faces initial selling pressure, especially if: -in a different industry than parent -parent is in an index and subsidiary is not Subsidiary also initially has low analyst coverage -Analysts and investors may not initially know much about the company Over time: -Selling pressure ends -Analysts coverage picks up Subsidiary benefits from: -Being a focused company -Fewer agency problems, incentivized management, etc.
Scania has two share classes, A and B. Immediately before the offer, the A share traded at a discount of 3 SEK, perhaps because it was less liquid than the B share. What do you think the discount was at close on February 24? Argue why your answer is consistent with the answers given to the questions above.
If the offer is completed then both share classes will have the same value. Given the high completion probability from above, the spread should be much smaller after the announcement (whatever the reason for the pre-announcement spread of 3 SEK was). With a 90% completing probability, the spread should be SEK 0.3. In fact, it narrowed to SEK 0.1.
A hedge fund with $10 million of equity trades on the belief that the CC Stub value underestimates the fundamental value. Shorting is feasible and margin requirements are 25% for both long and short positions. The fund allocates $2 million equity to cover the margin requirement of this trade, leaving $8 million in free equity. After a while, UB shares have appreciated to $34 while CC is still trading at $100. How much free equity has the fund left (i.e., equity not used for margin):
Let X denote the number of CC you buy. Then you need to short 4X UB. The margin requirement is 25% so total margin required for the position is 25% X ($100 + 4 * $29) = 25% X ($216) = X $54. If you allocate $2M equity to the trade X = $2M / $54 = 37.037. Free equity changes for two reasons. 1. The value of your position changes. 2. The margin requirement changes. The value of your position decreases because you lose($34 -$29) on each of the UB shares you are short. That is 4 * 37,037 * $5 = $740,740. The margin requirement increases because the value of the short position increases by $5 per UB share you are short. That is an increase in margin requirement of 25% * 4 * 37,037 * $5 = $185,185. In sum, your free equity is now $8M -$740,740 -$185,185 = $7,074,075. A more elaborate solution would be to constructthe initial balance sheet. It would show total equity of $10M of which $2M are needed to support the long and the short and $8M is free equity. Then the value of the short increases while the asset side remains unchanged. Hence, total equity decreases by the change in the short. That is the $740,740. Finally, you need to calculate how much equity you need to support the long and the short. For the long there is no change but for the short you need more equity. That is the$185,185. In sum, total equity decreases by $740,740 but free equity decreases by a further $185,185.
CC Corporation with one million issued shares is trading at $100 per share. CC owns four million shares in UB Corporation while one million UB shares have recently been floated. UB is trading at $29. CC will distribute its remaining holdings in UB to CC shareholders within three months. The risk-free rate is 0%. What is the CC Stub value:
MV(Stub) = MV(parent) -MV(stake) = $100 * 1M -$29 * 4M = -$16M
How will it affect the prices on a put and a call option, if it's expensive to short?
Put will be expensive Call will be cheap
Company AQ has offered to purchase all outstanding shares in company TAR. AQ is offering two AQ shares per TAR share. After the announcement AQ is trading at €50 and TAR is trading at €90. The risk-free rate is -1% annually. A merger arbitrage hedge fund decides to take a position in this merger situation. The fund finances its long position with equity. The annual interest rate obtained on the short proceeds is 1% below the risk-free rate. The deal is completed successfully after three months. What is the return obtained by the hedge fund (as a percentage of the long position)?
Return on long position = 100-90 = 10 Financing cost for short position = -2%*(3/12)*100 = -0,5 Return = 9,5/90 = 10,6% "The interestrate on the short proceeds is -1%-1% = -2%Total interest paid per two AQ shorted is €100 * (-2%) * (3/12) = -€0.5 Return per TAR share purchased is €100-€90 -€0.5= €9.5 corresponding to 10.6% of the long position."
What is the difference between a spin off, split off and carves out?
Spin off: -The shareholders of the parent company receive shares in the subsidiary on a pro-rata basis (no cash changes hands) - More common than split off. Split off: -The shareholders of the parent company can select to tender their shares in exchange for shares in the subsidiary. Carves out - In an equity carve-out, the parent sells some shares of the subsidiary while retaining a fraction of the shares on its own balance sheet.
Offer price is 200 Consider options written on Scania B shares with expiry on September 19, 2014 and strike price SEK 150. Assume that, on February 21, call options traded for SEK 12 and put options traded for SEK 13. Approximately at which prices do you think these options traded at the close on February 24? Do you think the Black-Scholes formula would have been appropriate to calculate the price of these options at close on February 24? Why?
The Black-Scholes formula assumes that stock prices evolve smoothly based on the Normal distribution (more precisely, a geometric Brownian motion), which is clearly not true for the Scania stock price. The Scania price is likely to jump at least when the resolution becomes known. Resolution before September 19 is very likely, let's assume it is certain to happen. Then there is a 90% probability that the call is worth SEK 50 and 10% probability that it worth SEK 12 (the pre-announcement option price), i.e. the call should trade at approximately SEK 46.2. You may get a different answer, but the option value should not be less than the intrinsic value (the stock price minus the strike price) of SEK 44.5. Also, the option value should be less than SEK 50 unless you assume that completion may be at a higher price than SEK 200. The put will only be valuable in case of failure and should have a value of about a tenth of its pre-merger value, i.e. approximately SEK 1.3. Clearly, owners of a straddle (a call and a put) profited from the takeover announcement.
What is the difference between merger premium and deal spread?
The merger premium is the difference between the pre-merger price and the offer, while the "deal spread" is the difference between the post-merger price and the offer.
In some cases, the price of the takeover target exceeds the offer price after the offer is announced. What are some possible reasons for such a negative deal spread?
The most natural explanation of a negative deal spread is that there is a non-trivial probability that the offered price will increase either because of a competing bid or because the current acquirer needs to persuade more shareholders to accept the offer. A possible, though less likely, explanation is that the bid and associated merger discussions reveals new information about the value of the firm.
The company AAA is carrying out a rights issue. Shareholders in AAA will receive one subscription right per share held. Five subscription rights and a cash payment of €10 entitle the holder to receive two AAA shares and one AAA warrant. An AAA warrant entitles the holder to subscribe to one AAA share in one years' time at a price corresponding to 50% of the AAA share price in one years' time. Assume that AAA doesn't pay dividends. The "ex-day" is November 29, 2017 (i.e., shares purchased on that day or later do not receive subscription rights). On November 28, 2017, AAA shares closed at €8. What is the fair value of AAA shares on November 29:
The value of the warrant is equivalent to the value of 0.5 shares since it entitlesto subscribe to one share at a 50% discount. Hence five rights and €10 gives you the equivalent of 2.5 shares.Value preservation from cum to ex day: €8 = S + RNo arbitrage on cum day: €10 + 5R = 2.5SSolve for S = 6.67 and R = 1.33
