the securities loan of $900,000 plus $23,000 in interest.
1
The fund also
returns the shares in Company A to the securities lender, who repays the
$1 million collateral deposit along with $15,333 in interest.
2
The gross
profit of $100,000 is reduced to $77,333 after financing expenses and
dividends. See Table 4.1.
As described, the trade would require no initial investment of capital
because the full value of the long and short positions is financed. In reality,
however, the hedge fund would need to put up excess collateral on both
sides of the financing trades. Also, the net outflow of cash for dividend
payments would be funded out of hedge fund capital. It is also important
to point out that, if the deal collapses and the shares of Company B revert
to the previous trading level, the hedge fund could face a loss of $200,000
before financing expenses (adjustment in price from $90 to $70 per share
on 50,000 shares).
This example is considerably simpler than many merger deals. In some
deals, the acquiring company offers a mixture of stock, cash, and bonds in
the merged entity. Also, even if the purchase is completed, the buyer may
not buy all the shares offered for sale.
The merger arbitrage strategy removes much of the risk from general
equity market price movement because the hedge fund buys one security
and sells short another. As long as the deal is completed, the positions are
hedges. However, the hedge fund is completely exposed to the risk that the
deal will not be completed. As a result, this trade performs worst when an-
nounced deals are canceled. The strategy can offer poor returns when
merger activity declines.
Event Driven--Bankruptcy
Most investors seek to avoid investing in companies that become bank-
rupt. Hedge funds may invest in securities of companies that face likely
62
HEDGE FUND COURSE
TABLE 4.1
Hedge Fund Profit from Company A
Acquisition of Company B
$100,000 Gross profit on shares
­$ 12,500 Dividend 4/15
$ 5,000 Dividend 5/15
­$ 12,500 Dividend 7/15
$ 5,000 Dividend 8/15
­$ 23,000 Interest on borrowed money
$ 15,333 Interest on collateral
$ 77,333 Net profit
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