Let's say there's some company A here.
And let's think about what its stock might be doing.
Let's say this is just over the course of the day.
Let's say its stock is just trading right over here.
So as we go through the day, it's price naturally changes.
But then right over here-- let's say this is within the day,
maybe this is happening at 10AM Eastern
Time-- an announcement comes out that B intends to acquire A.
I don't know, let's say that right now A
is trading at $5 a share, but a press release comes out
that B intends to acquire A at $10 a share.
So you can imagine-- And they say
they're going to do it with cash.
And we'll talk in future videos about how
it becomes a little bit more involved if they're
going to be doing it with their own shares,
but they intend to do it with cash.
So if they're able to acquire A, everyone
who owns a share of company A will get $10 for it,
and those shares will go to company
B. Company B will own company A all of a sudden.
So what do you think would happen
to the stock of company A?
We know that B intends to buy it for $10 a share.
Well, you could imagine if everyone thought
that this is definitely going to happen,
that anyone who holds the stock is going to get $10.
You could imagine that the stock would just gap up immediately
to something close to $10 a share.
And then not even trade much around it,
because they know what they're going to get for it.
So this is if you knew that this merger or this acquisition
was going to happen.
The reality is, is that you don't always
know just from this press release
that B definitely will acquire A. Maybe
they have to get approval from government bodies
to make sure that they aren't getting a monopoly here.
Maybe they still have to get the funding from some bank,
they still have to get a loan in order
to be able to do this deal.
Maybe something else happens.
Maybe there's another bidder who wants to acquire A
and they're willing to pay more.
So you don't know exactly what's going
to happen in this situation.
So you don't know for sure this is going to happen.
So what does normally happen is that instead
of going all the way up, it goes someplace in-between.
So the reality, instead of jumping from $5 to $10,
it might jump from, I don't know, $5 to $8,
and maybe it trades around here.
You might say, well, why does it trade at $8?
And it would trade at $8-- so notice,
if there was 100% chance it would trade all the way to $10,
right, because that's what stock A would be worth now,
because B is going to pay that.
But if it trades at $8 essentially the market
is saying that we're going to give you 3/5.
From $5 to $8 is $3.
So it's giving you 3/5 of the total jump that it
could have if it was 100% chance.
Or another way to say it is, is that the market
is saying that there is a 60% percent
chance that this merger will go through.
Anyone who thinks that there's more than a 60%
chance-- if they do this over a bunch of securities,
so that all the probabilities kind of work out eventually--
they should buy this security.
Because they could buy at $8, and they think
it really should be worth $10.
Anyone who thinks that, no way that this acquisition is going
to happen, B isn't going to get the financing
or the regulatory authorities aren't going
to allow B to do this, then they should short the stock
when it goes up here.
Because if the acquisition falls through,
then the stock is going to go back down here.
It's going to go back down to the $5 range
before the announcement.
And so people, and especially hedge funds,
who act in this way based on their thinking
that the merger is more likely to occur
or less likely to occur-- based on their research,
or maybe they have some quantitative models,
or maybe they have some information other people don't
have that might be legal or might be otherwise--
they would place these bets.
The people who think that the merger will happen,
will buy expecting it to go to $10.
The people who think it won't, they will short,
expecting it to go to $5.
And this strategy of playing the probabilities of a merger
happening, this is called merger arbitrage.
Merger arb, sometimes called for short.
And it's arbitrage because someone
who feels like they know the merger is going to happen,
they can buy something for $8 and then sell.
Or they could buy something for $8
that is going to be worth $10.
They can sell it for $10 at some future date
when B acquires a company.
Or, if they know the merger isn't going to happen,
they can short it for $8 and then buy it back for $5.
Once again, kind of doing an arbitrage on a price
differential.
They think something that's worth $5
is trading at $8 on the down side.
On the upside, they think something that's trading at $8
is worth $10.