Risk Arbitrage

Merrill Lynch just signed a deal with Bank of America to be purchased for 0.8595 shares of BAC for every share of MER. Markets are down on the news, but some hedge funds will be profiting.

Arbitrage involves simultaneously buying low and selling high the same commodity or investment in different markets. Risk arbitrage is a very close cousin.

MER is currently priced at about 21.17, and BAC is priced at about 28.36. Since each share of MER is worth about 86% of BAC, the truer price based on BAC's valuation should be about $24.

To take advantage of this price differential and to remove market correlation, a hedge fund manager would simultaneously short BAC while going long MER. As the prices of the shares reach the correct ratio, the manager should realize a profit of around 14% that is not correlated to the rest of the market. That is, the market can move up or down, and the manager would get his 14% either way.

The risk involved is if the deal falls through. If that's the case, as of now, MER shares will plummet, and BAC shares will shoot up, losing the manager money on each position.

If the manager is strongly opinionated about the direction of the market in the near term, he might choose to take only one side of the transaction, assuming the other side will be the losing end. That is, if he is bullish, he should buy Merrill. If bearish, short BAC.

I'm personally not taking action on this. In this market, anything could happen. The deal could collapse. MER might get an even stronger offer, making the position a wash. The terms could be restated. If I was running a hedge fund, I'd be doing it right now, because that would be my job description.