Risk Arbitrage

Also found in: Dictionary, Thesaurus, Financial, Wikipedia.
Related to Risk Arbitrage: Merger arbitrage

Risk Arbitrage

The purchase of stock in a corporation that appears to be the target of an imminent takeover in the hope of making large profits if the takeover occurs.

Risk arbitrage is practiced by investors called risk arbitrageurs. The strategy can return large profits if a takeover occurs but can also result in large losses if the transaction does not take place. Obviously, then, the more information an arbitrageur has about a possible takeover, the less risk the strategy involves. Buying Securities of takeover candidates on the basis of rumors is legal, but it is illegal for an arbitrageur to purchase securities based on inside, or nonpublic, information. Insider trading violates rule 10(b)-5 of the Securities Exchange Act of 1934, 15 U.S.C.A. § 78a et seq., which is a federal law that governs the operation of the stock exchanges and over-the-counter trading.

To obtain information, arbitrageurs often develop relationships with investment banking firms and corporations, as well as with other sources of information and financial backing. These activities alone do not constitute a violation of the Securities Exchange Act, but if the risk arbitrageur uses these relationships or resources to gather information that is not available to the general public, the resulting purchase of securities is illegal.

In the late 1980s, the Securities and Exchange Commission (SEC) began to investigate several prominent risk arbitrageurs for their roles in insider trading. This action, combined with the increasing number of corporate takeovers, brought the issue of risk Arbitrage to the headlines of Wall Street and the world. Between 1980 and 1988 in the U.S. District Court for the Southern District of New York alone, fifty-seven arbitrageurs were criminally prosecuted for insider trading. One of the bestknown cases involved risk arbitrageur Ivan Boesky, who allegedly realized a $9.075 million net profit through stock trades he made based on nonpublic information about three different mergers and takeovers. As part of the settlement with the SEC and the federal courts, Boesky was barred from any future securities trading.

Because risk arbitrage can involve significant blocks of shares worth hundreds of thousands, even millions, of dollars, this practice can have a large impact on both the market and the value of the company's stock. Professionals in the securities field generally agree that risk arbitrage based on inside information has a negative effect on the market, as well as on the reputation of arbitrageurs in general. Many of these commentators, however, are concerned that existing securities laws do not reach risk arbitrageurs who do not owe a fiduciary duty to the people who are harmed by the arbitrageur's use of nonpublic information. The Securities and Exchange Act specifies that a violation of rule 10(b)-5 requires the accused violator to have breached a fiduciary duty to the injured party.

Chiarella v. United States, 445 U.S. 222, 100 S. Ct. 1108, 63 L. Ed. 2d 348 (1980), is one of the leading cases on rule 10(b)-5 liability. Vincent F. Chiarella was employed at a financial printer and, as part of his duties, handled a series of documents that detailed an upcoming takeover bid; although the names were left blank or falsified, Chiarella was able to figure out the companies involved. Then, without disclosing that he had inside information, he bought stock in the companies that were targeted in the takeover; when the takeover was made public, he sold the shares and made a profit of approximately $30,000. Shortly thereafter, Chiarella was indicted on seventeen counts of violating rule 10(b)-5. The U.S. Supreme Court reversed the conviction, however, on the grounds that Chiarella had not violated the rule because he was not a fiduciary and therefore did not have a duty to disclose.

Further readings

Hazen, Thomas Lee. 1989. "Volatility and Market Inefficiency: A Commentary on the Effects of Options, Futures, and Risk Arbitrage on the Stock Market." Securities Law Review 21.

Steckman, Laurence A. 1988. "Risk Arbitrage and Insider Trading—A Functional Analysis of the Fiduciary Concept Under Rule 10b-5." Touro Law Review 5 (October).


Mergers and Acquisitions.

Mentioned in ?
References in periodicals archive ?
It is interesting to explore the risk return characteristics for risk arbitrage on stock swap offers with collars.
When the economics of settlement is considered, however, the defendant may partially avoid the amount of liability that a court would set through risk arbitrage, even when his wrongdoing has been discovered and an action is prosecuted.
While emerging markets present attractive opportunities in terms of risk arbitrage, says Will Rhode, a research analyst at TABB and author of the new report, investment hazards loom: exposure to turbulent currencies; discriminatory tax and capital controls; cumbersome and expensive local red tape for local securities trading; unreliable technical and telecommunication infrastructure; and immature clearing and settlement systems.
Characteristics of risk in risk arbitrage. Journal of Finance 56, no.
Another paper that uses an ABS approach is by Mitchell and Pulvino [85], who analyze almost 5000 mergers from 1963 to 1998 to characterize the risk and return in risk arbitrage. Results indicate that risk arbitrage returns have zero correlation with the market during up-market conditions, but large positive correlation during down-market conditions.
Exploiting this inefficiency is known as risk arbitrage.
Second, issuing bonds for the purpose of investing the proceeds in pension fund assets is a classic example of risk arbitrage: "the simultaneous purchase and sale of assets that are potentially but not necessarily equivalent." In this case, the bonds (perceived by buyers as low-risk securities) are sold and the proceeds invested in riskier--and presumably higher yielding--securities.
Risk Arbitrage: An Investor's Guide (New York: John Wiley and Sons, 1999.
The risk arbitrage approach involves the same analysis as the cost cap to determine the PML.
The web site, which soon will feature an afternoon update on risk arbitrage, is integral to the Daily Deal package, but print is at the core because the target audience includes many commuters, print is portable and the paper-Web combination is formidable.
Baker's and Nye's New York-based risk arbitrage firm, Baker, Nye Advisors, will also lend administrative assistance to Bond, Procope.
A great growth industry on Wall Street has been risk arbitrage, where people bet on the rise, or fall, of stock prices.

Full browser ?