Chartered Financial Analyst Level 2

Explanation

In merger arbitrage, the strategy involves buying the target company's stock and potentially shorting the acquirer's stock. The payoff profile resembles:

• Riskless bond component: Represents the spread between the current market price and the acquisition price
• Short call option component: Represents the risk that the deal might fail

Why Option B is Correct:

1. Merger Arbitrage Structure:

   • Long target company stock
   • Potential short position in acquirer stock
   • The strategy profits from the spread between current price and acquisition price

2. Option Analogy:

   • The riskless bond represents the guaranteed spread if the deal completes
   • The short call option represents the risk that the deal fails (similar to being short volatility)
   • If the deal fails, the target stock typically falls significantly, similar to the payoff of a short call option

3. Risk Profile:

   • Limited upside (the spread)
   • Significant downside risk if deal fails
   • This asymmetric payoff matches a riskless bond + short call option combination

This structure is fundamental to understanding merger arbitrage risk-return characteristics in alternative investments.