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FRM Part II · FRM Exam Part II · Hedge Fund Investment Strategies

A hedge fund runs a cash-offer merger arbitrage strategy. It buys the target's shares after a takeover announcement at a price below the offer price. Which statement best describes the source of the fund's expected return and its main risk?

The return in cash merger arbitrage is the spread between the market price and the offer price, compensating for deal-completion risk. The key risk is deal failure, when the target price drops sharply, producing a payoff of small gains versus large losses, similar to selling insurance.

  1. AReturn comes from the spread earning a premium for deal-completion risk; the main risk is deal failure, which causes the target price to fall sharplyCorrect
  2. BReturn comes from the target's long-term earnings growth; the main risk is a rise in interest rates after closing
  3. CReturn comes from shorting the target and buying the acquirer; the main risk is a rival bidder emerging
  4. DReturn comes from volatility of the target stock; the main risk is the target price rising above the offer

Explanation

In a cash deal the arbitrageur buys the target at a discount to the offer and earns the spread if the deal closes. The payoff is asymmetric: small gains if completed, large losses if the deal breaks. Shorting the acquirer applies to stock-for-stock deals, not cash offers, so option C is wrong.

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