Sorry!! The article you are trying to read is not available now.
Thank you very much;
you're only a step away from
downloading your reports.

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.

No positions in stocks mentioned.

The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

Copyright 2011 Minyanville Media, Inc. All Rights Reserved.

Featured Videos