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Risk/Volatility Arbitrage



I have received several requests to discuss actual examples of some of my positions; so here's one.

First Data Corporation (FDC:NYSE) has offered to buy Concord EFS (CE:NYSE) in an all stock deal: CE shareholders are to receive .4 shares of FDC. With FDC trading at approximately $39 per share, CE stock should be trading at $15.60 (39 x .4); however, it is only trading around $13.70. This "arbitrage spread" of $2 is due to:
1) the risk of the deal not going through
2) the cost of carrying the position until the deal does goes through. "Risk Arbitrage" traders will buy CE and sell FDC and earn that $2 spread if they believe the return provided by the spread warrants the risks.

We are not necessarily interested in this spread, but we are interested in the difference in the option prices of the two companies. The FDC at the money options expiring in January of 2005 are trading at an implied volatility of 27%. This is a level that we are comfortable in buying regardless of the outcome of the deal. If the deal does not go through, the stock normally trades at this volatility. If it does go through, CE is a more volatile stock, so the combination should drive the volatility higher.

The implied volatility of CE January 2005 options is currently around 45%. This level is lower than the 60% "fair value" we would give it, but has been dragged down due to CE trading more on the movements of FDC. Based on our assumptions of the probability of the deal going through and the resulting stock prices if it doesn't, we believe it is still a good risk/reward to be neutrally long FDC options and short CE options. Based on the vega of the FDC options, if the deal goes through we believe we can make $1.50 as the implied volatility of the options merge. Based on the vega of the CE options, we believe we could lose $.60 if the deal collapses. In order to capture this spread, we set up a delta neutral options position long FDC options and short CE options. To protect against the risk, we could set up a reverse arbitrage position long FDC and short CE (we decided against this).

Option traders not set up professionally (access to cheap leverage and low transaction costs) should not employ this strategy. The option spreads are also prohibitive in entering the trade if just executing through brokers. We, on the other hand, have more efficient methods of entering into the position.

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No positions in stocks mentioned.

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