Hedge Fund

hedge funds may combine trading in shares of companies involved in merg-
ers, bankruptcies, and/or divestitures. The largest subgroup of event driven
hedge funds invests in merger arbitrage.
The merger arbitrage strategy developed first at broker-dealers.
Many traders have left the dealer community to form hedge funds, and
other traders have copied the strategy. These traders typically buy the
target of a rumored or announced merger and sell short the shares of the
acquirer company.
One a company announces a bid to acquire a target, share prices
quickly reflect the terms of the proposed acquisition, adjusted for the
chance that the deal with close, financing costs, and other factors. The tar-
get company is usually purchased at a premium to the level the company's
shares traded at prior to the bid effort. For this reason, merger arbitrage
traders may try to anticipate a takeover attempt. Although share prices
quickly reflect takeover news, traders may try to acquire positions quickly,
before prices fully reflect the takeover proposal.
To understand the nature of merger arbitrage, consider a hypothetical
example. Shares of Company A are trading at $20. Shares of Company B
are trading at $70. You estimate that Company A will pay a quarterly div-
idend of $.25 per share on January 15, April 15, July 15, and October 15.
You estimate that Company B will pay a quarterly dividend of $.50 per
share on February 15, May 15, August 15, and November 15.
On March 15, Company A announces a bid to buy Company B, ex-
changing five shares of A for each share of B. Trading in Company B
shares is immediately suspended and trading resumes the next day at $90.
You buy 10,000 shares of Company B and sell short 50,000 shares of
Company A.
The shares of Company B cost $900,000 ($90
x 10,000). Suppose for
simplicity that you are able to borrow the entire amount at an annual in-
terest rate of 5 percent. (For a more complete discussion of the stock loan
market and leverage, see Chapter 6). The sale of Company A shares gener-
ates cash of $1 million. However, to be paid this amount, the hedge fund
must simultaneously deliver the shares. The fund borrows the shares but
must collateralize the loan with $1 million in cash. On that cash, the secu-
rities lender pays an annualized rate of 3 percent.
The hedge fund expects the deal to be completed in six months.
Therefore, it must make a substitute payment of $12,500 ($.25 per share
on 50,000 shares) on April 15 and July 15. The hedge fund receives a
dividend of $5,000 ($.50 per share on 10,000 shares) on May 15 and Au-
gust 15. Finally, on September 15, when the deal is completed, the hedge
fund receives 50,000 shares of Company A in exchange for the 10,000
shares of Company B. To complete the transaction, the hedge fund repays
Hedge Fund Investment Techniques
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