Financial Risk Manager Part 1
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A portfolio manager overseeing a merger arbitrage fund is evaluating an anticipated acquisition in which Company STZ will trade 1/3 of its stock for each share of Company ACQ. Currently, Company STZ's stock is priced at CNY 30 per share, and Company ACQ's stock is priced at CNY 9 per share. Considering the manager's high confidence in the acquisition's successful completion, which of the following trading strategies would be most appropriate for the manager to pursue to align with this expectation?
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A
Take a leveraged long position in 100,000 call options on Company ACQ.
B
Buy 100,000 shares of Company ACQ and short 30,000 shares of Company STZ.
C
Buy 30,000 shares of Company STZ and short 100,000 shares of Company ACQ.
D
Sell 100,000 puts on Company ACQ with a strike of CNY 9 and buy 30,000 calls on Company STZ with a strike of CNY 30.
Explanation:
B is correct. In a merger arbitrage transaction on a share-based exchange, the manager should go long the undervalued target and go short the acquirer if they believe the acquisition will be completed. In this case, STZ is paying a third of a share for each share of ACQ, which would imply a price of 10 per share instead of 9. Therefore, the manager should purchase an amount of ACQ shares and short an equal monetary value of STZ shares, and will profit when the relative value of an ACQ share rises from 0.3 per share now to 0.333 share as the acquisition is completed.
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